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Interest rate increases: Time to pause?

Sudden signs of inflation spur debate on whether the Fed is on the right track with its plan for short-term rates.

By ASSOCIATED PRESS
Published May 6, 2006

NEW YORK - Is it really time for the Federal Reserve to stop raising interest rates?

That's the question the markets have been grappling with since new Fed chairman Ben Bernanke told Congress late last month the central bank may be ready to pause in its drive to raise short-term interest rates to head off inflation.

Yet no sooner had the markets absorbed that idea when suddenly there were signs everywhere that inflation was on the rise - in prices paid for materials in the manufacturing and service sectors, in higher gasoline prices and in the sharp jump in workers' wages reported Friday by the Labor Department.

As a result, bond prices have been falling and market interest rates have been rising, with the yield on the benchmark 10-year Treasury bond touching a high of 5.17 percent this past week vs. about 4.8 percent just a month ago. On Friday, the 10-year bond was yielding 5.10 percent.

"There's concern that at the same time we're seeing widespread inflationary pressures mounting in the system, the Fed seems positioned to pause" in its rate hikes, said Kevin Cronin, head of investment for Putnam Investments in Boston.

Cronin and most other analysts expect the Fed to raise its target for the federal funds rate, which is charged on overnight loans between banks, to 5 percent on Wednesday, its 16th consecutive quarter-point increase since it began raising short-term rates in the summer of 2004.

Analysts are divided on what happens after that, but some clearly see a pause as a potential problem.

"With the Fed signaling it's going to pause, and people looking at an inflationary environment, investors are beginning to build that risk premium back into the marketplace," Cronin said.

He pointed out that a month ago, the yields on two-year, five-year, 10-year and 30-year securities were clustered around 5 percent; going forward, he said, people are saying, "I need more yield to go from cash to two years to 10 years to 30 years." And so rates are rising.

Stock market investors have appeared to ignore the tensions in the bond market, focusing instead on continuing strong economic growth, as seen in robust retail sales figures this week and solid first-quarter corporate earnings reports.

"The economy is strong, earnings are strong," said Brian Williamson, an equity trader at the Boston company Asset Management. "Inflation is creeping in, and the Fed may raise rates, but that's okay if they do it and do not create a drag on the economy."

But Liz Ann Sonders, chief investment strategist for Charles Schwab, said she was getting "a bit worried" about pricing pressures.

"I don't think there's a big risk of long-term, systemic inflation like in the 1970s," she said. "But there is near-term risk that will keep the Fed on its toes and, in turn, represents risks for the (stock) market."

She noted that a rise in bond yields traditionally "hasn't boded well for equities." Although there's generally a lag, she said, "the equity market can only go up so much in the face of a breakout in long-term yields."

Mark Vitner, senior economist at Wachovia Securities in Charlotte, N.C., said that while interest rates are going higher, they're relatively low.

"I don't think interest rates will rise to the point in the next several years where they'll become an impediment to the economy," Vitner said.

He added that the higher rates "in some ways are taking some risk out of the economy because they're taking the edge off the housing sector, making it harder to speculate." Strong demand, some of it from speculators, has driven home prices to record levels, creating concerns in some regions that there could be a crash.

Vitner sees oil prices "as probably the biggest risk out there."

[Last modified May 6, 2006, 08:18:24]