Rate increases coming, but not too soon
By Greg McBride, CFA • Bankrate.com

Could 2004 be the year interest rates start climbing again? Although the refrain is familiar to that heard one year ago, it may actually happen this time around. Unlike similar prognostications for 2003, this year begins on the heels of robust economic performance in the past six months.

Fed governors are belting out a different tune, one that sings the praises of the low inflation environment and will facilitate keeping interest rates low for a considerable period. Not everyone is buying it though. The federal funds futures market -- which allows traders to "bet" on when the Fed will change rates -- pegs a 46 percent chance of a quarter-point rate hike by June and an 84 percent chance by July.

Some predictions have the first interest rate hike arriving sometime as late as 2005. This is hard to fathom. The Fed increases rates when the economy is in danger of overheating, and it's clear the economy is already revving up: Growth is estimated at 4 percent or more, and the current economic recovery is forecast to continue. And though the Fed has said it will not increase rates until signs of inflation are clear, there are already a few hints of it -- rising oil and gold prices most obvious. But if the economic forecasts for 2004 turn out to be accurate, 2005 may be the year when the Fed's rate-setting body, the Federal Open Market Committee, really gets busy.

While 2004 may come to represent the first baby steps in a longer FOMC campaign of boosting interest rates that spans a couple of years, repeated interest rate hikes this year are unlikely for several reasons. Low inflation gives the Fed great latitude to keep rates low, as does the current slack in the labor and production markets. Worth noting too, is the November presidential election. While this would not handcuff the Fed from doing what was economically needed, the Fed is likely to remain hands-off in the latter portion of the year if for no other reason than to remove any potential influence on the outcome. Should the first move come by August, as market expectations have consistently indicated, this might buy the FOMC time until after the election before jumping in with both feet.

Of course, there are permanent asterisks that must be affixed to any forecast to reflect the realities of the world we live in, with terrorism and geopolitical concerns at the top of the list. The economic aftermath of Sept. 11 and the economic holding pattern leading up to the war with Iraq testify to the frailty of an unfolding economic recovery in the face of world events.

How will consumers' pocketbooks be affected if the FOMC begins only to nudge interest rates higher in 2004? Don't expect much in the way of improvement on CD yields until they get serious about boosting rates repeatedly. After all, it took 13 interest rates cuts over 30 months to bring yields down to the current dreadfully low levels. Although it won't necessarily take an equally aggressive campaign of raising interest rates to bring yields back to what could be termed "normal" levels, it isn't something that will happen on the back of two or three carefully timed interest rate hikes. If those hikes are sparked by an alarming jump in inflation, yields may rise quickly but without a corresponding benefit to depositors. Earning 4 percent if inflation is 3 percent is no better than earning 2 percent when inflation is 1 percent.

Credit card debt represents a particular exposure to higher rates, as even a fixed rate credit card is no haven from rising rates. While many homeowners have taken advantage of low rates to refinance mortgages and extract cash to pay down credit card debt, the fact is that revolving debt has increased nearly one-third in the past five years. As of November 2003, the total of $739 billion in outstanding revolving debt trumps the $563 billion outstanding as of Nov. 1998. While that may not all be credit card debt, it is predominantly tied to variable interest rates that will increase the burden of debt on already-strained consumers.

Greg McBride is a senior financial analyst for Bankrate.com.

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