Fed Halt Could Hurt You

I think the financial markets are essentially right. Growth does look like it will taper off -- but not fall off -- in 2006, and inflation looks tame.

The 56 economists polled by The Wall Street Journal, as part of that paper's quarterly survey, forecast that the U.S. economy will slow from 3.6% growth in the first quarter of 2006 to 3% growth in the fourth quarter. Inflation, measured by the consumer price index, will be lower in May, at 3.1%, than November 2005's 3.5% level, the economists predict. That would be enough, by itself, to move the Fed to the sidelines.

We'll all feel the effects of the end of the Federal Reserve's rate hikes, whether as consumers, as borrowers (home or credit card) or as investors. Here's how:

More Expensive Imports

The dollar will weaken and make imports from Europe, Japan and maybe even China more expensive -- and may, in turn, bump up the inflation rate. (Indeed, the dollar dropped 1.67% against the yen, 2.34% against the euro and nearly 2% against the pound last week.) The Federal Reserve's aggressive increase in short-term interest rates gave overseas investors, who provide the cash to finance the huge $700 billion annual U.S. trade deficit with the rest of the world, confidence that inflation in the U.S. wasn't about to get out of control. (Runaway inflation would lead to the kind of gigantic increases in interest rates that wipe out bond investors.)

That confidence will take a hit as the Fed moves to the sidelines -- and overseas bond buyers have already got to be a little worried about what happens when the untried Ben Bernanke replaces the deeply trusted Alan Greenspan as Federal Reserve chairman on Jan. 31.

Once confidence starts to erode, doubts can snowball. In this case, that means the dollar's value could fall. On Jan. 5, China indicated that it "could" begin to diversify its foreign-exchange reserves -- about 70% in U.S. dollars now -- away from the U.S. dollar and into other currencies. (China's foreign-exchange reserves are projected to hit $1 trillion in 2006.)