Monday, April 03, 2006

Federal Reserve Will Raise Rates Again in May

On March 28, the Federal Reserve Open Market Committee (FOMC) raised rates for the fifteenth time since June of 2004. With a probability of almost 100 percent, investors across the globe had already priced in the rate hike. More importantly on March 28, the FOMC announced that they remained ready to raise rates again depending on the "data." Of course the market took this statement as evidence of another rate hike at the Fed's next meeting. In fact, currently investors place the likelihood of a rate increase at the Fed's next meeting on May 10 at 80 percent.

Our monthly survey results have just been released (to be posted later today) and they underpin the market's assessment:

Our Business Conditions Index for the Mid-America region points to brisk second quarter growth, but with potentially higher inflationary pressures, according to the monthly survey of supply managers and business leaders in the nine-state region. The overall index for March climbed to 63.6, its highest level since November 2004 and up from February’s 59.9.
The region is rebounding from the slower fourth quarter 2005 growth. However, this upturn is contributing to somewhat higher inflationary pressure.

The prices-paid index, which tracks inflation at the wholesale level, for March rose for the first time since September 2005 to 78.6 from February’s 74.3. In January I placed the likelihood of a Federal Reserve rate hike in May at less than 10 percent. I now set the probability of at least a 25 basis point or quarter percent increase at 90 percent when the Fed meets again on May 10.

I believe the Fed should stop right now with the rate increasing. At 290 basis points, the real federal funds rate (actual rate minus inflation) is already well above its average for the past three decades. In my judgement, the Fed, and the rest of us, have been fooled by the warmer than normal weather. That is, the economic data that the Fed is using to justify rate increases is overly robust due to warm weather which has propelled construction activity for quarter one. Growth in the second half of 2006 will be significantly restrained by the Fed action. There is even rising potential for a recession (remote at this point-in-time).


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