It's been a long time since economists dared to consider former Federal Reserve chief William McChesney Martin's deathless phrase that it is the Fed's job to "take away the punchbowl just as the party gets going." But with Wall Street surging and both business and consumer confidence on the mend, the question at the moment is not if interest rates will rise in 2004, but when. Some believe the first hike could arrive as soon as May, especially should the economy continue to sizzle.
After several years' worth of setbacks and false starts, the economy is showing clear signs of robust growth, helped at least in the short term by a series of presidential-sized tax cuts. How much oomph is left to carry growth into the next several quarters remains to be seen.
Regardless, George W. Bush seems quite jolly about the health of the economy as the new year is beginning, with GDP clocking an astounding 8.2% annual rate of growth for the third quarter, the manufacturing sector in a rebound and capital spending on the rise. The notable exception–and it is clearly a big one–is payroll growth. No doubt, the shape and timing of a recovery in employment will go a long way toward determining the size and timing of the Fed's next move. In the meantime, the nation's surging productivity rates and lean payrolls have helped to send corporate profits up 30% in the third quarter of 2003.
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The shift in confidence is evident in T&RM's semiannual survey of CFOs, treasurers and controllers on the outlook for the economy. Coming in at an average score of 71, on a scale of 1 to 100, confidence about the next six months is higher than at any point since late 2001. That compares with an average of 62.4 from the last survey. Also much stronger than in past years' surveys is the percentage of financial executives who say they expect their company's capital spending to increase in the next six months (43%). The same question drew a 28.5% average response in the last survey. The percentage of executives who said their company's operating margins should grow in the next year rose to 67% from 60.2% from the prior survey.
The fed is willing to wait for now
There is less cheer, however, in the survey's employment outlook. Nearly 30% of executive respondents expect a reduction in their workforce in the coming 12 months, a figure that rose sharply from previous surveys. That result suggests that many of the largest companies in the economy are planning to keep riding the productivity wave to meet demand for as long as they are able, or at least into 2005.
As for Alan Greenspan and the rest of the Fed policy makers, the challenges may be only starting. There remain few signs that inflation is perking up, but what exactly does the Fed mean when it says that policy accommodation can be maintained for a considerable period? With the federal funds rate at 1%, economists argue that there is plenty of room for short-term interest rates to rise in the months ahead and still have the Fed maintain an "accommodative" position. "Most economists believe that the fed funds rate needs to rise to between 4% and 5% just to make monetary policy neutral, let alone tight," said Diane Swonk, chief economist at Bank One. "This provides the Fed with a variety of options to raise rates and remain 'accommodative' in the near term." It now seems hard to believe, but as recently as early 2001 the federal funds rate stood at 6%.
The risk the Fed faces: An economy far stronger than is apparent. If that is the case, a sudden surge in inflation that could force the Fed's back against the wall and require a series of sharp rate hikes in 2004 and 2005 is more than just a possibility. "They can't wait for actual inflation [to appear]," argues Ian Shepherdson, chief U.S. economist at research group High Frequency Economics. Since it takes 12 to 18 months for rate changes to have their full impact, he believes the Fed risks creating an inflationary spike by late 2005 should the economy get any hotter or the central bank delay raising rates too long. "Growth is steaming, rates are low and it takes a long time for rate [changes] to take effect." Diane Swonk of Bank One sees bottlenecks already forming in certain technology components and says there is an upside risk for 2004, where the economy could exceed already robust forecasts. "Much of what we're seeing in the business sector is catch-up activity, not just related to the stimulus."
Although rapidly rising interest rates are at best an outside possibility, should they occur they could have a destabilizing impact on many industries. "One of my worries for 2004 is how many poorly conceived investment strategies will be revealed by fast rising federal funds rates," says John Lonski, chief economist at Moody's Investors Service. Excessive leveraging, poor use of derivatives and careless borrowing strategies laid out during the low-rate years could easily unravel in an environment of rapid and successive rate hikes and create problems for the markets. So far, Lonski does not envision this scenario taking shape, given his expectation that inflation should be relatively well contained near term.
In general, economists are expecting the next several quarters to remain strong, but well off the searing level of the third quarter. According to the most recent consensus forecast of 52 economists by Blue Chip Economic Indicators, GDP in 2004 is expected to rise at a 4.4% annual rate, while consumer prices are expected to rise by 1.9%. David Wyss, chief economist at Standard & Poor's Corp., expects GDP growth of 4.7% in 2004. With the unemployment rate at 5.9%, he reckons the economy is operating about 2.5% below capacity. "Until that gap is closed, there is no reason to expect domestically generated inflation," Wyss argues.
Consumers may get stingier
With interest rates widely expected to rise, there may be challenges ahead for some consumer-related businesses. The housing market and the ability of consumers to borrow in a low-interest-rate environment have clearly kept the economy on its feet for some time despite a weakened corporate sector. A slowdown in housing demand is expected to put some pressure on housing prices in 2004. As a result, housing-related companies could feel a sudden chill, according to analysts, if consumer purchasing power is stifled by rates. Automakers, which can be especially hard hit by upward shifts in short-term rates, are also expected to feel the pinch.
Mortgage lenders are already becoming more cautious. Washington Mutual, the second-largest home lender, recently lowered its outlook for 2004, citing weakness in the lending marketplace in what may be just the start of uncertain times ahead for big lenders. But other financial service companies may thrive in the new economic environment. "Given expectations of a stronger economy in 2004, loan loss provisions at many financial services firms should in general continue to benefit," says Barry Kroeger, Americas director of banking services at Ernst & Young.
The risk of rising rates is one of the markers of an expanding economy. But after two years of sloshing through the snows of subdued growth, it's a risk very much worth taking.
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