The Interest-Rate Debate
Everyone has an opinion. But higher and sooner sounds right.


David Malpass

Interest-rate hikes will be hotly debated in Washington and in the media in the coming weeks. How much will rates rise, and how soon? And what factors are behind the rising rates?

Three recent newspaper articles, mostly contradictory, search for the answers.

U.S. Treasury Secretary John Snow’s views were discussed in an interview by Anatole Kaletsky in the October 20 London Times. The Times’s website has two versions of the article, one entitled “U.S. interest rates to rise soon,” and a longer, updated version called “Snow boasts spring has sprung for U.S. economy.” Secretary Snow discussed three topics: the strength of the economy (at length), interest rates, and the dollar.

Per Kaletsky, Snow said that Washington would welcome an increase in interest rates as a reflection of strong U.S. economic and job growth. Snow discussed the strength in consumption, housing, and productivity growth. He used colorful language: “I would stake my reputation on employment growth happening before Christmas. I’d bet dollars to doughnuts that we’re going to see a pickup in jobs in the next few months.”

The article stated that Snow refrained from discussing monetary decisions in the interview. Treasury spokesman Rob Nichols said that Snow was talking about market interest rates, and not the federal funds rate. But it’s important to note that Secretary Snow meets regularly and at length with Federal Reserve Chairman Alan Greenspan (the overlord of the fed funds rate), and that the two usually have a consistent view on the growth outlook.

In the Times interview, in fact, Snow “rejected the widely held view on Wall Street that the Fed never raises interest rates before a presidential election,” calling it mythology. He’s right. The Fed hiked rates five times in 1988 and three times in 2000.

In contrast, however, an October 19 Washington Post bond column by John Berry rejected the view that recent comments by Fed officials are hinting at an increase in interest rates.

Without citing a source, Berry wrote: “The comments, which were technical in nature, should cause no concern. As long as significant amounts of slack remain in both labor and product markets and inflation pressures are nil, any increase in the [interest rate] target remains well in the future.” (The italics are mine.)

Berry’s comment is an output-gap view of Fed policy-making. The point about rate hikes being “well in the future” is consistent with the Fed’s formal statement that “policy accommodation can be maintained for a considerable period.” But the output-gap model is backward looking and would cause harmful volatility if used as a rigid monetary-policy rule.

For a third take on the situation, the October 20 Wall Street Journal had an article by Greg Ip about monetary policy. The piece was headlined: “Fed considers target for inflation; Greenspan opposes move, but some of his colleagues draw closer to a consensus.” The article said that a consensus may be forming around the idea of the Fed stating an “optimal long-run inflation rate” so that markets would have a general idea when the inflation level was below or above target.

The article also said that Fed governor Don Kohn calls the benefits of an inflation target exaggerated. Kohn is right. Inflation targeting would be a negative development, likely moving the Fed even farther away from market-based indicators of monetary policy. Inflation targeting worked very poorly for the European Central Bank in 1999 and 2000 and poorly for Brazil in 2001 and 2002, severely hampering their economic growth.

So, here’s what’s likely to happen. As part of a constructive reflation process, U.S. interest rates will rise sooner and more than current market expectations. Evidence of a “slack” in the economy will diminish in coming months and inflation rates will turn up due to the dollar weakness in 2002. This will allow the Fed to raise rates while leaving it conveniently unclear which model it is using.

There is something called the Taylor rule, which incorporates implicit targets for potential growth and inflation. It might predict a 2.4 percent and rising overnight rate for current economic conditions (the overnight rate is now 1 percent).

But it would be preferable for the Fed to move toward a forward-looking model that uses market-based indicators of future inflation. And the model should seek dollar stability as a key step in achieving low inflation and allowing high average growth rates.

Putting aside how we get there, interest-rate increases will be supportive of fast economic growth and equity outperformance over bonds and cash. That’s because interest rates will be rising toward a more normal level — and markets will be able to focus on the improving level, not just the increase.

Similarly, it’s been positive to see the dollar weaken about 25 percent from its peak — not because dollar weakness is good, but because the dollar is moving toward a more normal, pro-growth level.

So let the hot debate begin. But remember where interest rates are headed: up sooner and more than expected.

– David Malpass is the Chief Global Economist for Bear Stearns.