Fed drops first rate-hike hints
By Greg McBride, CFA • Bankrate.com

It becomes clear by reading the Federal Open Market Committee's Dec. 9 post-meeting statement that the Fed is transitioning to a period when it will need to raise interest rates. Unlike six months ago when the Fed last cut interest rates, the economic train is on track and the journey toward recovery is well under way. Along the way, we'll pass through a town known as "rising interest rates" and all indications are that it will be more than just a whistle-stop.

Subtle changes to the landscape are evident as the train chugs toward economic improvement and higher interest rates. An economy that in June was not showing sustainable growth is now "expanding briskly," a reference to third quarter Gross Domestic Product growth in excess of 8 percent. The Fed is no longer sounding the horn about deflation, noting that such a probability has "diminished in recent months."

The labor market, which has been the caboose on the economic train, is now "improving modestly." Perhaps indicative of this is the fact that 57,000 jobs were added in November. While just a few months ago this would have been heralded as great news, the result fell short of expectations. However, this number is subject to further revision and the current trend is that initial indicators are getting revised higher. A number that disappointed on Dec. 5 could well be revised to a more-impressive number by Jan. 5.

Such a revision would likely be under the radar, or at least buried under the headlines, and not produce an immediate response in financial markets. The FOMC does look at trends, however, and such a revision would bolster the trend of job growth that now extends back to August.

Looking beyond the Fed's statement also reveals some clues of higher rates to come. Mortgage lenders are announcing job cuts as the pipeline of loan applications that flooded lenders' offices over the past couple years threatens to slow further as rates rise higher. A reported surge in corporate bond issuance rings like a final "All Aboard" at current interest rates.

Productivity continues to soar, increasing at the fastest rate in 20 years during the third quarter. While rising productivity contributes to profit growth without a corresponding increase in prices, the current pace cannot be sustained. So two questions come to mind. If productivity is rising so darn fast, why aren't any of our expenses declining? And what happens to prices when this rate inevitably slows?

Although the Fed is certain inflation will remain low, the steady decline of the dollar may ultimately derail this. While welcome news to U.S. manufacturers of goods that are now less expensive on a relative basis in overseas markets, it contributes to rising prices here at home as imported goods now cost more. Further, the unsettling notion persists that a declining dollar will make foreign investors unwilling to invest in U.S. securities. This threatens to extinguish an important source of funding for the budget and trade deficits, forcing the Treasury to pay higher interest rates to entice borrowers.

Though projections of the first rate hike have been all over the map, including some that say nothing will happen until 2005, the federal funds rate futures market indicates otherwise. Often used to gauge expectations about future Fed action, the futures market pins the probability of the first interest rate hike at 76 percent by May and a 90-percent chance by June. The prevailing mood in financial markets causes these odds to fluctuate, with good economic news moving it closer to today, while disappointing news tends to push it back. As 2003 winds down, so too does the cycle of falling interest rates. While the exact timing is still unknown, 2004 seems certain to usher in a cycle of rising rates.

Greg McBride is a financial analyst for Bankrate.com.

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