When Federal Reserve policy makers meet on Wednesday, traders such as John Roberts at Barclays Capital Inc. will be watching to gauge whether an interest rate increase eases their concerns that inflation is accelerating. Fed policy makers will raise their benchmark rate Wednesday for the first time in four years, by 25 basis points to 1.25 percent, according to more than four fifths of the 133 economists surveyed by Bloomberg. The Fed has held the rate at 1 percent, the lowest since 1958, for a year.
Roberts said he and other traders will focus on the language Fed officials use to describe the threat of inflation in their statement. The consumer price index rose 3.1 percent for the 12 months ending May, up from a 2.3 percent annual rate in April. The economy has added 1.2 million jobs this year, the fastest annual growth rate in two decades. Consumer spending rose 1 percent in May, the largest gain since October 2001. ``They have got to indicate, number one, that they will continue to raise rates to get them to a level'' more consistent with U.S. growth and inflation, said Roberts, who oversees from New York one of the largest market-making operations in inflation- linked securities. ``And number two, that if inflation does gain a toehold, they will be fast to stamp it out.''
Economists disagree over what the Fed will revise in language from the previous meeting on May 4 that called for raising rates at a ``measured'' pace. Lehman Brothers Inc. economist Drew Matus expects the phrase to remain. William Dudley, chief economist at Goldman, Sachs & Co. says the U.S. central bank may substitute it with a more flexible term. ``They're walking a tightrope,'' said Roberts.
Forecasts
Of 133 forecasters polled by Bloomberg News, 112 expect a 25 basis point increase on Wednesday. Eighteen predict the Fed will hold at 1 percent, and three foresee a 50 basis point increase to 1.5 percent. The economy is now in its 11th quarter of expansion and an average 237,000 jobs have been added to payrolls each month in this election year. Economists, monetary policy researchers and traders say the Fed has to raise interest rates to keep prices - - and the reputation it has built over two decades as an inflation fighter -- in check. ``Cyclical forces are promoting somewhat higher inflation and the Fed understands that monetary policy is too accommodative,'' said Richard Berner, chief U.S. economist at Morgan Stanley in New York. ``Both appropriate rhetoric and action are now needed to make good on the commitment to keep inflation expectations and inflation itself'' low.
Too Slow?
Even if the Fed raises its target as forecast, the overnight lending rate, minus the consumer price index without food and energy prices, will remain less than zero -- just as it has since October 2001. Never in the almost 17-year history of the Greenspan Fed have interest rates been so low for so long. A slight increase in credit costs are not likely to diminish banks' incentive to lend and consumers' desire to spend, economists said. If the overnight rate remains ``below the inflation rate, they are moving too slow,'' said Michael Darda, chief U.S. economist at MKM Partners in Greenwich, Connecticut, and one of the forecasters predicting an increase to 1.5 percent. In early 2003, the Fed's emphasis was protecting against a possible further slowdown in price increases -- disinflation --or declining prices through deflation that would jeopardize corporate profits, economic growth, and jobs as companies slashed costs. That lead to the June 2003 cut to 1 percent.
Shifts in Language
Since August last year, the Fed has used language to guide traders' expectations about the path of rates. The Fed started out by saying it could hold rates low for a ``considerable period''; then that they could be ``patient'' before starting to raise rates; and, since their May meeting, that they expect to start raising rates at a ``measured'' pace. Language is becoming a less convincing substitute for action, said Michael Bordo, a member of the National Bureau of Economic Research Monetary Economics program, and director of Rutgers University's Center for Monetary and Financial History. ``I think the Fed has been behind the curve,'' said Bordo, who has written or co-written 10 books and more than 100 research papers on monetary history and theory. ``They over-reacted to deal with deflation a year ago and waited too long to tighten up.''
Inflation Rate Rising
Inflation is rising in government measures and in private surveys. The personal consumption expenditures price index, a measure closely monitored by the Fed, rose at a 3.2 percent annual pace in the first quarter, up from 2.1 percent a year ago. For May, the price index rose 0.5 percent, the largest rise since September 1990, and it is up 2.5 percent over the past twelve months. Minus food and energy, the index is up 1.6 percent since May 2003, within a range of stable prices defined by some Fed officials. The University of Michigan's June survey of consumers shows expectations of 3.3 percent inflation over the next year, a nine- year high, according to a report by Greenwich Capital Markets. Consumers are paying 29 percent more for gasoline at the fuel pump, and 22.8 percent more for milk at the grocery store than they did last year. Companies are also able to pass along price increases. General Mills Inc., the second-largest U.S. cereal maker, has raised prices as much as 9 percent on brands including Progresso Soup and Totino's snacks to cover higher fuel and ingredients costs. Even prices on manufacturing equipment are starting to firm up, said William Zadrozny, president and chief executive officer of Siemens Financial Services, the Iselin, New Jersey lending unit of Siemens AG.
No Surpise
``It is the first time in three years we have seen consistent demand,'' Zadrozny said. One reason: ``The Fed is pumping enormous amounts'' of money into financial markets, he said. Fed officials have acknowledged in recent speeches that prices of industrial inputs and consumer goods are moving up. They have prepared markets for a rate increase, in part to avoid a repeat of February 1994 when the Standard and Poor's 500 index fell 2.25 in response the first rate increase in about 17 months. ``There certainly isn't going to be any surprise this time,'' said William Poole, president of the St. Louis Fed, on June 15. ``I don't think there has ever in history, in U.S. history anyway, been a better advertised forthcoming rate increase.'' The Greenspan Fed has started every cycle of rate increases over the past decade with a 0.25 percentage point move, so even the size of this week's likely increase is fairly predictable. What's uncertain is the effect it will have on expectations about inflation. Both Fed officials and traders have said they will be watching. Roberts points to the 10-year inflation outlook implied by yield differences on 10-year Treasury notes and TIPS of similar maturity. Inflation expectations, measured by the spread between Treasuries and TIPS, have averaged 2.60 percent over the past three months, up from 2.37 the previous three months.
So long as the spread stays around 2.5 and 2.6 percent, he says, the Fed can raise rates gradually. If inflation expectations move above 2.7 percent and stay there, the Fed will be far more aggressive, he says. ``Our Fed has more credibility of any other central bank in the world,'' said Roberts, answering a computerized trade request from a customer with a couple of key strokes. ``It is great for me as a trader. I know what they are going to do.'' Barclays is one of largest market-makers in U.S. inflation indexed bonds, according to TradeWeb LLC, an online trading network. ///www.bloomberg.com