Road Map to Higher Interest Rates (Part 1)

by: Lou Basenese

<< Return to Part 2

So when will the Federal Reserve (finally) raise interest rates?

The question has remained at the forefront of economic discussion ever since the Fed lowered interest rates to between zero and 0.25% roughly 30 months ago.

And following the Federal Open Market Committee’s (FOMC) unanimous 10-0 decision last week to leave rates unchanged again, inquiring minds still want to know.

But here’s the dilemma facing the Fed.

Hike rates too soon and it could thwart the fragile economic recovery. Wait too long and it could usher in a period of runaway inflation.

Clearly, neither outcome is desirable. So how is the Fed going to navigate this difficult situation? And when can we truly expect the Fed to raise interest rates?

Can You Get Inside a Banker’s Brain?

Predicting the innermost economic thoughts of Fed Chairman Ben Bernanke and his fellow bankers is darn nigh impossible.

However, about 16 months ago, I put together a “Road Map to Higher Interest Rates,” which spelled out the specific events that should precede the most anticipated hike in history.

Today and tomorrow, I’m going to revisit that list to see how far we have – or haven’t – come. Here goes…

The First Three Signs of the End of Free Money

It’s important to remember that the Fed adjusts interest rates based on inflation expectations. And right now, there’s still too much slack in the economy for inflation to be an immediate concern.

Accordingly, the Fed is unlikely to consider a rate hike until these three economic data points noticeably improve:

~ Unemployment: One of the biggest contributors to economic slack is the unemployment rate. We’ll need to see a definitive return to job growth before the Fed even considers increasing interest rates. As a general rule of thumb, the Fed usually waits at least a year before raising rates after the unemployment rate peaks.

Although we’re more than a year removed from the peak unemployment rate of 10.1% (in October 2009), it remains uncomfortably high. And the trend isn’t moving in the right direction, either. In March, the unemployment rate dipped to 8.8% before jumping back up to 9.1% in May. Based on this, the Fed is likely to keep waiting.

~ Factory Utilization: If our factories aren’t running at full-tilt, there’s no way the economy is, either. That was certainly the case during the throes of the recession, when factory utilization neared a record low of around 72%. In the last two decades, the Fed has waited to raise interest rates until factory utilization rebounded to the historical average of about 80%.

While it’s true that the factory utilization rate has improved, rebounding to 76.7% in May, we’re still below the 80% threshold. And considering that the utilization rate has remained stuck at the same level for all of 2011, this suggests the Fed is going to wait a while longer here, too.

~ Wages: Economic slack also shows up in wage growth. After all, when companies are ferociously cutting costs and employees are worried about simply having a job, raises are virtually nonexistent. Given the severity of this downturn, it’s no surprise that wages fell at their fastest pace in 25 years. We need to see a pronounced rebound before the extra money in consumers’ pockets prompts the Fed to increase its inflation expectations and, in turn, raise rates.

Although personal income rose by 2.08% in the first quarter, the U.S. Bureau of Economic Analysis concedes that most of the growth can be attributed to a two-percentage point reduction in the Social Security tax. So again, we need to see more improvement here before the Fed would consider hiking rates.

Based on the economic data, it’s clear that we have considerably more ground to cover before an interest rate hike is imminent. But we can’t rely solely on the economic data to guide us… it’s also instructive to examine the actions of the Fed. So tomorrow, we’ll do just that.

I’ll share four more waypoints on our “Road Map to Higher Interest Rates.” As you’ll learn, we’ve definitely covered some ground… but is it enough to predict a hike in rates before the end of the year? Stay tuned to find out.