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Living With Rate Hikes
The positives outweigh the negatives.


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David Malpass

The markets are now pricing in more rate hikes from the Federal Reserve and some inflation. That’s appropriate. This is not a Goldilocks economic environment of fast growth and low inflation. The gold price and bond yields are up; equities are down. There is a moderate inflation problem today, and the Fed’s dealing with it.

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The issue now is whether or not inflation is going to be worse than what markets have priced in, and whether or not the Fed will have to react abruptly. Probably not on both fronts. The Fed has gotten a lot of the anti-inflation work done. It has hiked the federal funds rate from 1 percent to 3.75 percent and the markets now expect several more hikes. (The Fed won’t be able to pause until at least 5 percent.) The dollar, meanwhile, stopped weakening at the end of 2004.

To be sure, expensive energy has become a drag on the economy while home equity extraction will probably slow. But the household and corporate sectors are well insulated from Fed rate hikes. If unemployment falls toward 4.5 percent, as it likely will do, it will more than offset the negatives.

Those who fear inflation and a spike in interest rates should keep a couple of things in mind. First, the Fed is powerful in combating inflation. Second, current inflation is caused by monetary accommodation and dollar weakness in 2003 and 2004, not economic growth or cost-push factors. Thus, inflation is likely to be a moderate bulge, and not a secular trend. Finally, the markets may have already priced in most of the inflation/interest-rate problem.

In short, as rates rise, this economy will keep growing. The household sector is a big net creditor and is well insulated from rate hikes. As bond yields rise, the losses are well distributed in the U.S. and abroad.

I also don’t think the anticipated moderate inflation bulge and related rate hikes will be as negative for the corporate sector as some contend. Businesses have enjoyed substantial operating leverage as the expansion has progressed, partially insulating them from rising energy and interest costs. The result has been strong growth in profits. For non-financial corporations, price per unit of output has increased 0.9 percent over the last year, while production costs per unit declined 0.9 percent.

Recent data also show that the economy was strong going into Katrina and Rita and apparently remained strong despite the hurricanes. Industrial production, orders sales, and the forward-looking Institute for Supply Management (ISM) index are all strong when the hurricanes are taken into account. Auto sales have been weak in October, but this is no surprise. More, in recent years, short-term weakness in auto sales hasn’t set a trend for the economy or the consumer, and has instead reflected auto-pricing issues.

For the third quarter gross domestic product should drop sharply to 3.5 percent. After that, GDP should rise sharply, hitting 4.5 percent in the fourth quarter. It projects to then lower to 4.2 percent for the first quarter of 2006 and 3.8 percent for the succeeding quarters. However, growth challenges do exist for 2007 and 2008, such as the threat of tax increases, the likely absence by then of monetary policy accommodation, and possible slowdowns in housing and consumption.

On the jobs front, the unemployment rate did climb to 5.1 percent in September, but it should move below August’s 4.9 percent in coming months. Job growth outside the Katrina-impacted region appeared to be steady at 190,000 in September, according to the Labor Department, and the rebuilding effort should only add to employment. Adjusted for the hurricanes, weekly jobless claims have dropped below 300,000. Except for 1999 and 2000, this hasn’t happened since the 1980s (when the labor force was much smaller).

Today’s relatively strong expansion has been underway since 2002, and there’s good reason to expect the U.S. economy to grow quickly in the fourth quarter and into 2006. And while the inflation bulge and Fed rate hikes will continue well into 2006, they shouldn’t stop the durable expansion or equity market gains.

– David Malpass is the chief economist for Bear, Stearns.



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