Rate Tightening: When, Not If - TheStreet

Rate Tightening: When, Not If

Pressure is building on the central bank to raise rates; the debate is whether it'll be June or August.
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The prospect of higher interest rates continues to stalk the financial markets.

On Wednesday, concerns the

Federal Reserve

will have to tighten monetary policy sooner vs. later were heightened by a higher-than-expected consumer price index report and a narrowing of the U.S. trade deficit. On Tuesday, a host of strong economic news

slammed the bond market.

As stronger-than-expected economic data have poured in during the past month, Fed tightening seems to be a foregone conclusion. The only question is when the first rate hike hits.

Brian Wesbury, chief economist at Griffin Kubik Stephens & Thompson, worries that the Fed will wait too long to start lifting rates. "The economy is clearly on a sustainable growth rate here

and stronger than people think," Wesbury argued. "Inflation is definitely more of a risk now ... and if the Fed waits, it will be too late to stop inflation."

The government said CPI rose 0.5% in March vs. expectations for a 0.3% gain, and is now up 1.7% vs. a year ago. Core CPI, which excludes food and energy, rose 0.4% in March, its biggest monthly increase since late 2001. (Many economists believe CPI understates inflation; for some time, other measures such as commodity prices and the spread between inflation-protected and regular Treasury securities have indicated greater inflationary pressures than the "official" government proxy.)

Wesbury pegs the odds of a Fed move by the end of August at 100%. "If you believe all of the recent data, we need to have a rate hike today," he said. Indeed, a Fed move before the Aug. 10 policy meeting is highly likely, he said, placing a 90% chance of the Fed moving in June or before. He thinks a move in May or before has a 60% chance.

Wesbury, who had thought a first-quarter rate hike seemed likely, remains more aggressive in forecasting tightening than most market participants; currently, fed funds futures put the odds of a rate hike at about 10% for the Federal Open Market Committee's May 4 meeting and 46% for its June 30 meeting, according to Bianco Research in Chicago. However, expectations for the June meeting are up from just 10% on March 31, and the futures are forecasting nearly 100% odds of a rate hike at or before the Aug. 10 confab.

John Lonski, an economist with Moody's Investor Services, says "it behooves the prudent investor to not be surprised by a Fed hike at the June 30 Fed meeting." He believes there's a 60% chance of the Fed moving at the June meeting.

Even if the Fed did move in June, a 2.5% fed funds rate still doesn't constitute tight monetary policy, given the current economic backdrop, Lonski said. With the funds rate currently at 1%, tightening from here should be thought of with that perspective in mind.

Like Wesbury, Lonski worries that the Fed could find itself in a tough spot if it doesn't stay ahead of the curve. "For the Fed to wait for inflation to rise significantly is like the investor who waits for a company that is on the brink of bankruptcy," he said. "The Fed would be doing the financial markets and the economy a great favor by gradually lifting the fed funds rate to a neutral rating."

In other words, the Fed should not wait, unless it wants to find itself having to play catch-up later in the year (or in 2005) and ends up raising interest rates too far, too fast.

"If you are a fan of gradualism, then you would favor a gradual lifting of rates that would benefit above-average economic growth and a bottoming of inflation," Lonski said.

Referring to the strong March employment report released April 2, Joel Naroff, chief economist at Naroff Economic Advisors, said: "If we get one more decent jobs report, the Fed won't be able to say the labor market is soft."

If the April and/or May jobs reports are strong, the Fed might start tightening in June, Naroff suggested. "But that would take heated-up inflation and robust job growth." His prediction is that the Fed moves in August, suggesting a "less than 50% chance of a move in June."

Either way, he said the Fed needs to start moving -- or indicate it will be moving -- soon.

A Fed statement at the May meeting hinting at future tightening "probably doesn't give them enough time to start moving in June," Naroff added. "With the labor markets coming around and inflation moving off the dime, I would handicap it for August."

Politics provides a final reason for the Fed to increase rates sooner rather than later. Many investors wrongly believe the Fed won't alter monetary policy during presidential election years, for fear of influencing the outcome. In fact, the Fed has been quite active in past election years, though the central bank has generally preferred to not raise or lower rates between Labor Day and Election Day.

In fact, avoiding any appearance of influencing the election is an argument for the Fed to tighten earlier rather than later, said Wesbury. Wesbury says it makes sense to get the hike out of the way prior to the election, and then resume a tighter monetary policy afterward. His model calls for a 100-basis-point hike during 2004, with 50 basis points before the election and another 50 sometime after the election.