Fifty Basis Points or Bust, Say Fed Forecasters

Not only will the Fed hike the fed funds rate by 50 basis points tomorrow, it will also issue a statement indicating it remains concerned about the potential for inflation to accelerate, Wall Street forecasters are saying. The central bank doesn't dare do otherwise, the forecasters assert.

But for all the agreement on that point -- 27 of 29 top Wall Street dealer firms polled by Reuters are looking for a 50-basis-point hike -- there is remarkably little consensus on how the Fed will proceed in the months ahead.

A 50-basis-point hike in the fed funds rate tomorrow, to 6.5% from 6%, would be the first rate action of more than 25 basis points since the 50-basis-point hike that ended the last tightening cycle, in February 1995. It would take the fed funds rate to a level not seen since 1991. And it would be the sixth rate hike by the Federal Open Market Committee since June.

What makes the forecasters so sure that the FOMC will get aggressive tomorrow? In part, the Fed's own words. When the minutes of the committee's Feb. 1-2 meeting were released on March 23, we learned that its members -- some of them, anyway -- were prepared to consider lifting the funds rate by double the usual amount. At the February meeting, the minutes say:

A few members expressed a preference for an increase of 50 basis points in the federal funds rate in order to provide greater assurance against a buildup of inflationary expectations and inflation over coming months. Other members acknowledged that the Committee might need to move more aggressively at a later meeting should imbalances continue to build and inflation and inflation expectations clearly begin to pick up.

Then, inflation and inflation expectations clearly began to pick up. The March Producer and Consumer Price Indices both blew the average forecasts out of the water. But the real doozy came on April 27, when both the Employment Cost Index and the GDP report for the first quarter detected loads more inflation than expected. The ECI rose 1.4%, vs. an average forecast of 0.9%, and the GDP price deflator came in at 2.7%, vs. a consensus estimate of 2.2%.

On that day, the odds of a 50-basis-point rate hike this month, as measured by the fed funds futures contracts listed on the Chicago Board of Trade, shot up from 28% to 65%. By Monday, those odds had drifted up to 94%.

With the financial markets poised for a 50-basis-point hike, staying the gradual course would be a colossal mistake, market analysts say.

"This would be the worst possible outcome for the bond market," Wrightson Associates chief economist Lou Crandall writes in his firm's weekly newsletter. "The market might view the smaller rate hike as a pleasant surprise initially, but the glow would fade quickly. Fixed-income investors would quickly conclude that the FOMC shied away from a necessary rate hike for public relations reasons, and that the central bank was now in danger of falling behind the curve."

"The real bears in the bond market are those who think the Fed might tighten by just 25 basis points this week instead of 50," Crandall added.

The real bears and the clinically paranoid. Agreeing that a 25-basis-point rate hike probably would trigger a rise in long-term interest rates, High Frequency Economics chief U.S. economist Ian Shepherdson points out in a research note that "this is just what the Fed wants, given that it would increase the chance of a near-term slowdown by driving up mortgage rates sharply." But Shepherdson concedes that "raising rates by less than you believe is necessary in an attempt to generate a certain reaction in the Treasury market is a very risky strategy. It also fails dismally on the transparency test for good monetary policy: The Fed, we hope, wants the markets to know exactly what it is doing, and why."

In their statement announcing the policy action, the FOMC will likely opt for language indicating that the risks to the economy are "weighted mainly toward conditions that may generate heightened inflation pressures," as opposed to being weighted toward economic weakness, or in balance. Such language would suggest that additional rate hikes are likely in the months ahead.

"A neutral statement from the committee might leave the impression that officials feel they have taken sufficient steps to slow growth and contain inflation," in the analysis of Daiwa Securities chief economist Michael Moran. "Such a perception would probably trigger rallies in the stock and bond markets that would frustrate the tightening move," by easing financial conditions while the Fed is attempting to tighten them.

At the same time, the expected statement won't necessarily presage another rate hike of any size at the FOMC's subsequent meeting on June 27-28. The most popular forecast at the moment calls for the committee to hike the rate from 6.5% to 6.75% at that meeting. But while almost all forecasters agree that the fed funds rate is likely to see at least 7% by early next year at the latest, some say there are good reasons for the Fed to stand pat in June.

Another 50-basis-point hike is almost certainly out of the question, Wrightson's Crandall says. "A pair of back-to-back rate hikes of half a point each would qualify as a very significant policy shock, and the Fed is very mindful of how these play out, especially in overseas and emerging markets."

But even a 25-basis-point move is doubtful for June, Crandall says, noting that on each of the six occasions since December 1991 when the FOMC has changed the funds rate by 50 basis points or more, "it has then paused for at least one meeting before moving again." In addition, Barclays Capital senior economist Henry Willmore points out that "only six weeks separate the May and June meetings, with only one employment and CPI report released between them."

Any rate action in June will be small, Daiwa's Moran predicts. The economic statistics released in the intervening period probably won't call for another drastic move, he says. But also, he says, Fed officials remain open to the possibility that the economy is changing in ways that allow it to grow faster than it used to without causing inflation to accelerate. That possibility arguably has kept them from hiking rates more aggressively than they have over the last year.

The Fed has "a preference for gradualism if the data permit," Moran says. "The preference is likely to be even stronger in the current setting because of the uncertainty about the economy's structural change."