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 if 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. 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:
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.