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Fed Halt Could Hurt You

Think before you hail an end to rate hikes: Expect higher prices and a weaker dollar.
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On Jan. 3, the stock and bond markets decided that the

Federal Reserve

was near the end of a string of interest rate hikes that have taken short-term rates from 1% in June 2004 to 4.25% today.

Investors and traders cheered the thought. On the day, the

Dow Jones Industrial Average

climbed 130 points.

If the financial markets are right -- a big


that I'll look at in a minute -- what does the end to the Federal Reserve's interest rate increases mean for you? My best guess at the five most likely effects:

A weaker dollar and higher prices at the store.

Higher gasoline prices.

Higher mortgage rates.

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A continued rally in gold stocks and new life for financial stocks.

And an end-of-the-year surprise: interest-rate cuts from the Fed.

The Jan. 3 stock and bond market rallies were set off by that afternoon's release of minutes from the Dec. 13 meeting of the Federal Open Market Committee (FOMC), the Fed body that sets targets for short-term interest rates. The minutes said that the committee's staff had forecast solid economic growth ahead -- with economic output near the economy's potential -- but at a pace slower than in 2005.

Inflation, despite rising energy costs, was under control -- "benign," the minutes called it -- and there were tentative signs that past interest rate increases were starting to cool off the housing market. Some members now thought that interest rates were high enough to keep inflation under control.

To the financial markets, the FOMC was saying, about as clearly as it ever says anything, that one more interest rate hike -- at the Jan. 31 meeting -- or two more at most, would mark the end to interest rate increases. The string of 0.25-percentage-point increases would end, the market concluded, and short-term rates would peak at 4.5% or 4.75%.

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.)

Will other central banks follow China's lead, and how much diversification will overseas central banks seek? Depends on how good a job the Federal Reserve does in generating confidence in its policies after it stops raising rates.

Gas Prices Will Rise

Oil is priced in dollars, and anything that erodes the confidence of oil producers in the future value of the dollars they get for their oil will lead them to ask for more current dollars to make up for the risk. The OPEC (Organization of Petroleum Exporting Countries) and non-OPEC oil producers know they're sitting on a finite resource; if the dollar starts to decline in value, expect oil producers to factor that into their prices.

Mortgage Rates Will Rise

This certainly seems counterintuitive: How can you wind up paying more interest when the Federal Reserve has stopped raising interest rates? Because the interest rates on many mortgages are pegged to long-term interest rates -- such as that on the 10-year Treasury note -- but the Federal Reserve controls only short-term interest rates.

In 2004 and 2005, short and long rates converged. One reason was that, with the Federal Reserve raising short-term rates, investors felt that long-term inflation was under control and that they could accept a lower yield on a long-term investment, such as a 10-year bond.

On Jan. 5, the three-month Treasury bill yielded 4.19%, and the 10-year Treasury note 4.35%. That spread -- 0.16 percentage points -- isn't much for the added risk of locking up your money for 10 years. Rates on a 30-year fixed-rate mortgage ranged from 5.6% to 6.2% last week.

But with the Fed moving to the sidelines, with a new Fed chairman and with a falling dollar, the risks to long-term bondholders rise, and there's a good chance that long-term interest rates will start to creep upwards.

No one with an existing fixed-rate mortgage needs to worry -- unless they're looking to move up to a new home and need a new mortgage. But any increase in long-term interest rates will gradually take a bite out of the cash flow of anyone with an adjustable-rate mortgage.

Hard Assets, Financial Stocks Will Rally

Investors aren't just looking at the end of a period of rising short-term interest rates; they're looking at the end of a period of extreme predictability. Month in, meeting out, we knew what the Fed was going to do: raise short-term rates by another 0.25 percentage points. We knew inflation was going to stay under control, at least officially.

Whatever comes next has to be less certain than that. Already, hard-asset, safe-haven stocks that profit from gold, copper, timber and oil have moved up in 2006 on just the suspicion of future inflation. Gold closed at $541.20 an ounce on Friday, up 4.6% for the week. It's up 30% since the end of 2003.

Financial stocks will do well, not because they're safe havens in times of uncertainty, but because the end of the Fed's policy of raising rates will take the pressure off their profit margins. Banks borrow short -- from depositors or in the short-term commercial paper markets -- and lend long. They make their profits out of the spread between short-term and long-term rates. The collapse of the spread between short-term and long-term interest rates has cut into those profits.

The end of short-term rate hikes alone will help financial companies and their stocks, because no longer will the spread get smaller and smaller from month to month. A widening of the spread would be gravy for the sector, but it's not necessary for the sector to outperform in 2006.

Fed May Need to Cut Rates

The financial markets have come to rely on the godlike powers of the chairman of the Federal Reserve. With a tweak here and a polysyllable there, Alan Greenspan can tame inflation, goose growth, strengthen the dollar and -- after changing in the nearest phone booth -- fix liquidity crises with a single flood of cash. Or so the markets have come to believe.

The historical record, however, suggests that the Federal Reserve usually overshoots. It raises rates too much, and the economy starts to show signs of stalling. Or it cuts rates too much, and the financial markets show signs of an asset bubble. The odds, after what are likely to be 15 interest rate hikes over almost two years, are that the Fed will overshoot in 2006, as well. As Bill Gross, the bond guru of Pacific Investment Management, notes in his most recent newsletter, the Federal Reserve often has to cut rates within six months of ending a series of interest rate increases.

No guarantees, of course. But this is exactly the kind of unexpected turn of events that consumers, mortgage-holders and investors ought to expect.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York.