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The Federal Reserve is finished hiking interest rates, despite its warnings about the dangers of inflation. The central bank's Federal Open Market Committee (FOMC), which left interest rates unchanged at its latest meeting, is leaving the door open for more rate increases in the future, noting that "some inflation risks remain." However, we think that the recent decline in energy prices paves the way for a further slowing in the rate of inflation, while the weak housing market will prevent a resurgence of economic growth. That isn't the formula for higher rates ahead.
We see rates holding steady for several months—at least until spring. In practical terms, this means that the benchmark federal funds rate, which banks charge each other for overnight loans, will hold at 5.25%, while banks' prime rates—charged to their best customers—will stay at 8.25%. By around mid-2007, inflation will probably have eased enough to let the Fed drop its guard a bit on rates. Odds are that the central bank will knock off a quarter-point from the federal funds rate at that point, with the prime falling to 8%.
Judging by the interest rate futures market, investors think that the Fed's next move will be a rate cut early next year. But we're not convinced that the central bank will be ready to lower its guard that early. Indeed, the latest statement from the FOMC suggests continued tensions between inflation hawks and doves inside the bank. David Rosenberg, chief North American economist with Merrill Lynch, says, "This is clearly a fractious and divided Fed, as it generally is at turning points" in the economic cycle. It will take time for those more hawkish on inflation to become convinced that it is no longer a danger.
The inflation doves at the Fed will get a boost in late October, when economic growth numbers for the third quarter are likely to confirm the pronounced slowing trend. After posting a 5.6% gain in the first quarter, growth in gross domestic product (GDP) eased to 2.9% in the second quarter and will come in between 2% and 2.5% for the second half. For the whole year, GDP will increase about 3.4% before slowing to about 2.5% in 2007.
While the Fed frets about short-term rates, the financial markets will keep an eye on energy prices as bond buyers and sellers assess future inflation and set long-term rates. Uncertainty will keep rates volatile, with the 10-year Treasury note yielding between 4.7% and 5.25% in 2007, mainly near the low end of that range. The current yield is about 4.75%.
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