Is the Federal Reserve on its Way to Breaking the Economy?
On Friday the Department of Labor announced a surprising 274,000 jobs were created during April. Despite the strong jobs report the stock market showed just modest gains as concerns over a soft patch gave way to concerns about inflation. The strong report also erased any doubt whether the Federal Reserve would raise interest rates during its next meeting in June. This past week, the Federal Reserve pushed interest rates up another 25 basis points to 3% and maintained its pledge to raise interest rates at a measured pace.
The Federal Reserve is seeking to find a level where interest rates neither stimulate the economy nor provide a drag on future economic growth. At 3% the Fed Funds rate is nearing a level that would historically be considered neutral, but the difficulty facing the Federal Reserve is that while short-term interest rates are increasing, long-term interest rates are holding steady. Expectations for inflation to remain well contained over the foreseeable future and the continued accumulation of U.S. bonds by Asian Central Banks are providing upward pressure on bond prices. In general, economists expect the Federal Reserve to continue to increase the Fed Funds rate by 25 basis points at every meeting this year until short-term interest rates reach 4%. Should this expectation hold to true, it is nearly impossible for an investor to anticipate profiting this year on the purchase of a newly issued U.S. bond, which currently yields 4.3%. In February Alan Greenspan referred to the bond market as a conundrum, because long-term interest rates did not reflect the current economic environment. The conundrum presently facing the bond market is even more puzzling than that of which Mr. Greenspan was referring to earlier this year.
Eventually the Federal Reserve will raise short-term interest rates enough to impact the cost of borrowing long-term debt. As the yield curve continues to narrow it will become less profitable for large financial institutions to invest heavily in U.S. treasury bonds. The possibility exists a breaking point will occur within the bond markets that could drive long-term interest rates to an undesirable level. Spectacular appreciation in the housing markets and financial troubles at General Motors puts the Federal Reserve in the unenviable position of having to cool inflation in an environment where over-tightening could threaten the current economic recovery. The recent downgrades of GM debt to junk status raises warning signals over the possible impact should the Fed tighten too aggressively. Every interest rate hike by the Federal Reserve further deteriorates the balance sheet of General Motors and pulls the company closer to bankruptcy.
Financial Watch expects the Federal Reserve to raise interest rates at their next two meetings in June and August before pausing. Our forecast calls for short-term interest rates to peak at 3.5% during 2005, which is about 50 basis points below the consensus forecast. Financial Watch’s forecast is based on the expectation that economic growth and inflation for the U.S. economy will peak during the first half of the year. It is our belief that with a Fed funds rate at 3.5% the Federal Reserve will successfully eliminate the present inflationary pressures affecting the U.S. economy and force a more fundamental valuation of in the housing market without causing a crash.