Despite signs that employment and spending weakened in November, the Federal Reserve is likely to forge ahead with a quarter-point interest rate hike on Tuesday, its fifth in as many meetings. In addition, central bankers are expected to leave their policy statement largely intact, suggesting that more hikes could be on the way in 2005. Traders are almost fully pricing in a 25-basis-point move this week, which would leave the funds rate at 2.25%, up from 1% in June. The odds for a rate hike in February and March are also very high. "I don't see anything to throw them off the path of steady, measured increases," said Alexander Paris, an economist at Barrington Research. "Interest rates are probably still too low." With the economy growing at a respectable pace, Paris said there is no need for the stimulus that was put in place after the recession and terrorist attacks three years ago. Economists surveyed by Bloomberg News recently raised their estimates for fourth-quarter growth to 3.8% from 3.5%, citing a sharp decline in oil prices. Paris also noted that the falling dollar has become a growing concern. In November, Fed Chairman Alan Greenspan said that if foreign demand for U.S. assets wanes amid a burgeoning trade deficit, interest rates would have to rise to attract foreign capital, or the country would be forced to import less. Meanwhile, an article in The Wall Street Journal early this month suggested that some Fed officials are increasingly worried about inflation. Concerns center around high commodity prices, slowing productivity and the weak dollar, which raises import costs. Still, Bill Dudley, an economist at Goldman Sachs, doesn't expect the Fed to change its assessment that the "upside and downside risks" to inflation are "roughly equal."
"My view is that it is premature to expect a change in the balance-of-risks statement," he said. Indeed, inflation data have generally remained tame recently. In October, the core personal consumption expenditure index, the Fed's preferred measure of inflation, rose just 1.5% on a year-over-year basis.
If the Fed hints that it is concerned about prices, Dudley said, the odds of a 50-basis-point hike in February and March would increase "when there is no reason for the Fed to speed up at this point." "I expect that the Dec. 14 meeting instead will have more of the same: a 25-basis-point hike, a neutral balance of the risks as before, and the 'measured' phrase retained," he said. The central bank has said since May that policy accommodation can be removed "at a pace that is likely to be measured." In its last statement in early November, the Fed said output "appears to be growing at a moderate pace despite the rise in energy prices" and that "labor market conditions have improved." Economists say these two remarks could be tweaked, given the sharp decline in energy prices recently and disappointing jobs data. The Labor Department reported that just 112,000 new jobs were created in November. Meanwhile, planned layoffs remained above 100,000 for a third straight month, according to outplacement firm Challenger, Gray & Christmas. Job cuts rose 2.6% in November from the prior month and 5.1% from the same period a year ago. In addition, weekly unemployment claims have been trending up over the past two weeks. So far, the recent softening in the labor market seems to have offset any positive impact from the 23% decline in energy prices since late October. Consumer confidence deteriorated in November and the holiday shopping season has been sluggish so far. Economists say retail sales probably rose just 0.1% last month. If oil prices resume their upward trajectory, consumer spending could take an even greater hit in December. The National Weather Service is calling for below-normal temperatures in the eastern states from Dec. 14 to 18, which could result in higher demand for heating oil. Asha Bangalore, an economist at Northern Trust, said expansions that are three years old typically result in stronger job growth, and she worries that the outlook for the economy is worsening.
The Conference Board's index of leading economic indicators has fallen for five straight months and the yield curve has been flattening out, suggesting slower growth ahead. "Net-net, the weight of evidence suggests that the economy is not on firm footing and that there is more than a whiff of softening of economic activity under way," she said, noting that car sales have decelerated for two straight months and that new orders for capital goods are "sagging." "This could persuade the Fed to pause after a December-meeting interest rate hike and wait for convincing evidence of economic strength before resuming further rate increases." Economists surveyed by the Blue Chip newsletter and by Bloomberg expect short-term rates to rise to between 3.25% and 3.5% by the end of 2005. But others say rates will peak at much lower levels. Indeed, Merrill Lynch thinks the December rate hike will be the last. "You need repeated doses of stimulus either in the form of price cuts in retail land or stepped up incentives/rebates in the auto sector to bring economic growth above potential on a sustained basis," the firm said in a research note. "If the Fed wants to deliver tightening, then the stimulus job is up to the bond market." The yield on the 10-year Treasury note has fallen 42 basis points to 4.16% since June 29, the day before the first rate hike.