June 24, 2004

Expected Fed Rate Rises

The Wall Street Journal's Greg Ip details how the Fed is trying to prepare the financial market to take its medicine. Mary Poppins it ain't:

WASHINGTON -- Next week, the Federal Reserve is likely to end the easiest monetary policy in its modern history by raising interest rates for the first time in four years. And if all goes according to plan, the markets will barely blink. Fed officials are almost certain to boost their target for the federal-funds rate, charged on overnight loans between banks, to 1.25% from 1%, when their two-day meeting ends Wednesday afternoon. They have labored for nearly a year to ensure that this increase, and those to follow, are fully anticipated....

There may yet be surprises next week. Fed officials are wrestling with whether to indicate, as they did after their May meeting, that future rate increases will be "measured," a euphemism for moving in quarter-percentage-point increments....

Some analysts, citing mounting reports of rising prices, say the Fed has waited too long to raise its rates. But Fed officials note that the mere anticipation of a rate increase has had the practical effect of an actual increase. Long-term interest rates, including those on mortgages, are up sharply since March....

There are two reasons for the Fed's move to more explicit communications. One is to avoid the market turmoil set off in February 1994, when the Fed began raising rates after they had been flat for 17 months. At the time, futures markets were anticipating that the funds rate would rise from 3% to about 3.75% by October, according to Bianco Research LLC, a Chicago financial research company. In fact, the rate hit 4.75% in October and kept going, reaching 6% by the following February. The rapid tightening hammered stock and bond prices, indirectly contributing to the demise of Kidder Peabody & Co., the bankruptcy of Orange County and Mexico's peso devaluation. "There was a fair amount of surprise from time to time in the financial markets about how aggressively we were moving," Minneapolis Federal Reserve Bank President Gary Stern said in an interview earlier this year, noting that he would rather not repeat that experience....

Posted by DeLong at June 24, 2004 02:07 PM | TrackBack | | Other weblogs commenting on this post

The first thing Greenspan did as fed chairman was cause the crash of 1987. Of course portfolio insurance played a role and the question is what is out there this time like portfolio insurance.

But the experience of causing the crash of 1987
-- that essentially everyone believed could not happen -- had to give Greenspan such a scare that his behavior is still influenced by it.
The crash was so bad it even forced the academics to rewrite on the efficient market theory.

Historically, fed funds peak and trought with nominal personal income growth.
But now we are 2 years past the bottom of what is now very strong nominal personal income growth.

The Fed is way behind the curve -- funds should never have gone below 2.5% to 3%.

Posted by: spencer on June 24, 2004 02:39 PM


No one has anything to say about interest rates?

Posted by: c, on June 24, 2004 02:39 PM


And developments in Iraq are even causing Larry Kudlow to say bad things about the Bush Admin.

Posted by: spencer on June 24, 2004 02:41 PM


I really hate it when rich people might have to worry a little.

Posted by: masaccio on June 24, 2004 03:20 PM


I have a theory - that so many people have massively leveraged their house equity through ARMs, that any increase in the interest rate would outstrip their ability to continue payment. Since a fixed-rate mortgage costs more than an ARM up front, they won't be able to migrate to a fixed-rate mortgage - and since they can't pay the ARM any more, they'll be forced to sell or declare bankruptcy.

Assuming this happens on a large scale, could this rate hike be the beginning of the housing market bubble explosion?

Posted by: Thane Walkup on June 24, 2004 04:30 PM


I know the Fed's interest is making the American financial system happy (alas, not the American worker's but that's another story) but isn't this a really _bad_ time to raise rates? Won't raising interest rates stop foreign investment, leading similiar senarios like listed in the last paragraph of the article?

Why isn't anyone worried about what this is going to do to the rest of the world's? Or are we all convinced that raising interest rates will help reduce outsourcing...

is confused

Posted by: DEVGIRL on June 24, 2004 04:43 PM


c wrote, "No one has anything to say about interest rates?" It's a funny place that we are in. We know that we are about to start the back half of the Great Greenspan Experiment. There are alot of scenarios floating in people's heads about what will happen if the rates go up too fast or too slow, but people may not talk alot about it now. I think its sort of like talking about a movie right before it starts. Might as well wait to see how it turns out. My only comment would be to echo some of what Spencer said. Greenspan was very aggressive, and we have no idea of the size of the distortions that this has created in the economy. But we will all find out together.

Posted by: Keith on June 24, 2004 09:58 PM


How should Greenspan manipulate rates to prevent a Democrat from being elected this time?

Last time, with no signs of inflation at all, he jacked rates up and up and up until he destroyed Clinton's only positive, a good economy, thus undercutting Gore election bid.

This time, with signs of inflation everywhere, he raises rates the smallest possible amount, as late as possible, determined not to cause another Bush recession, in order to prevent Kerry's election.

Why do people think G is apolitical???

Posted by: tjallen on June 25, 2004 02:01 AM


Thank you tjallen for touching on Greenspan's political motivations. G's monetary policies can be very directly related to his polital adgenda. While he has been discredited in my eyes for most of his tenure, his support for bush*'s tax cuts and his compliant monetary policy for the last three years as he has tried desparately to keep the bush* policies from driving the recession even deeper have clearly revealed that ALLAN GREENSPAN IS A PARTISAN HACK.

Posted by: jsb25 on June 25, 2004 04:49 AM


To get ARM Shares of the Mortgage Market, see


From 2001-middle 2003, ARM shares were very low, but they have picked up since.

Posted by: Richard Green on June 25, 2004 04:53 AM


I'm not an economist, but I lean toward a 50 basis point hike, not 25.

I figure that the Fed thinks that they will need 2 hikes in the next 2-4 months, and it's bad mojo to raise the interest rates in October before a presidential election.

Posted by: Matthew Saroff on June 25, 2004 09:39 AM


I believe that we've been living on borrowed time and money for a long time -- unfunded entitlement promises and borrow-and-spend warmongering (war on poverty, war on drugs, war on terrorism).

Is there a next rabbit to be pulled from the hat to keep us afloat for a while longer? Or, Have Greenspan and Co. ran out of fancy tricks?

I probably spend too much time lurking near what might be called the Bears Lair. But for those like me who still worry that indeed we are near the end of the rope, try:

"Global economy: Hedge Funds & Bubble Trouble" for snippets from three recent Financial Times warnings from Philip Coggan (The Short View), Deborah Bruster (PIMCO Chief says economy is less stable than in past '20 or 30 years'), and Samuel Brittan (The Threat of Extreme Events)

Packaged together at:

Posted by: dabbler dave on June 25, 2004 10:22 AM


spencer writes "we are 2 years past the bottom of what is now very strong nominal personal income growth." Surely personal income growth was not growing in the last half of 2001? ( A small quibble)
And this: "Historically, fed funds peak and trough(t) with nominal personal income growth." sounds reasonable only to you and me, but Big Al tells us we are in different times now. And we are, but despite the seductive style ( I mean bull shit), the message is in his actions, not his words.
That chattable increase has remained just that. The risk of implementing it may be understood from the 1987 experience or the Bush Sr defeat, but I like Thane's view that the (im)plosion of the housing market, the precarious debt structures is/are what AG really does not want to test. I can see the FOMC huddling over their thesauruses trying to stretch "measured" to new heights.
Any increase will be delayed as long as possible. Any increase will be as little as possible. I see no one predicting anything but tighter money in a few months (after the election).

Posted by: calmo on June 25, 2004 10:32 AM


Calmo says "I see no one predicting anything but tighter money in a few months (after the election)."

There is a school of thought (particularly appealing to Goldbugs) that we may see initial tightening, then loosening as fear of deflation once again rears its head among the Fed and other power players and, speculating further, they try to reflate their way out of the mess.

See in particular, "Fed Monetary Policy -- Why 2004 is Not 1994, V. Anatha Nageswaran


...we reiterate our stance that the Federal Reserve would tighten monetary policy by about 50 basis points this year and not by 125 basis points as the market is discounting. Simply, there cannot be a repeat of 1994. Then, US household debt was low, the Federal budget had been turned around with a tax-increase and spending-cut budget in 1993 and there was no labour market arbitrage available from India, China and other developing economies.

Hence, inflation was bound to rise along with the economic cycle. The inflation demon has been slayed. To go to war against it with higher interest rates would be to bring back alive the demon of deflation that is always lurking around.

Indeed, as HSBC Chief Economist, Mr Stephen King, wrote: "... Cyclically, the arguments in favour of higher interest rates appear to make a lot of sense. Structurally, though, the higher debt levels today suggest we really cannot be sure what will happen when interest rates go up. And because of that, it's just as plausible to argue that initial rate rises could be followed by hurried rate cuts... " (June 1, 2004).

Posted by: Dabbler Dave on June 25, 2004 12:09 PM


Richard, you seem like a very informed person in this arena. When i look at the chart, i'm struck by the very dramatic change that takes place during '95. To what do you attribute this?

Posted by: howard on June 25, 2004 12:45 PM


I think it is really pathetic that the mainstream American cares more about Britney Spears engagement than our country. Until Americans wake up and get a clue these politicians and big buisness are going to ruin our country. Our last president was selected not elected. It is so frustrating that nobody cares! voting is the last thing on anybody's mind. Greenspan is raising the rates too little, too late. It is hard to believe he's not smart enough to see what is going on.'BUBBLE'. . . it's all a ploy to keep Bubba in the white house.

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