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[TTHQ Staff]

BEING STREET SMART
____________________

Sy Harding


NO END IN SIGHT TO RISING INTEREST RATES! June 10, 2005.

The Federal Reserve has raised short-term interest rates eight times over
the last 12 months in an effort to slow the economy enough to ward off
threatening inflation. In the process it has lifted the Fed Funds Rate from
its extreme low of 1% last June to its current level of 3%.

With reports like last week’s dismal employment numbers for May, and
declines in manufacturing activity and 1st quarter GDP, hopes had been
raised recently that perhaps the economy was slowing so much that the Fed
would be forced to stop raising rates. Otherwise it might risk sending the
economy over the edge into a recession.

However, while the Fed has been raising short-term rates, long-term rates
have remained flat and have even fallen some, as can be seen in lower
mortgage rates and lower bond yields. That is so unusual that Fed Chairman
Greenspan calls it a puzzle and a ‘conundrum’, a term he used again in
speeches this week.

Regardless of what you call it, the situation is thwarting the Fed’s efforts
to ward off inflation. Unless the Fed can get long-term rates to follow
short-term rates up, as they always have in the past, the Fed has little
chance of slowing the hot and inflationary housing market, or the mortgage
refinancing temptations that put more money in consumer’s hands to spend on
other things. So from that perspective alone the Fed must continue to raise
the Fed Funds rate until it does affect long-term rates. The Fed has always
been more concerned about the long-term harm of inflation than the shorter
term pain of a slowing economy, or even a recession.

>From his statements this week, the inflationary forces in the real estate
sector are clearly on the Fed Chairman’s mind, and high on the list of
concerns that put pressure on the Fed for higher interest rates.
Making the Fed’s job of warding off inflation even more difficult is the
inflationary spike up in oil and other energy costs over the last three
years, a situation over which the Fed has no control.

Meanwhile, the Consumer Price Index (CPI), measuring inflation at the
consumer level, has risen sharply, from 1.6% in 2001 to 3.3% in 2004, and
spiked up to an annualized 4.3% in the 1st quarter of this year. However,
the Fed refers to the so-called ‘core rate’ of CPI inflation, which is
calculated by leaving out the cost of food and energy, when, to keep markets
calm, it claims that inflation remains controlled, a claim that is at odds
with its course of raising interest rates to fight off inflation.

But the Fed is well aware that as long as we insist on eating an occasional
meal, putting gas in our vehicles, and heating our homes, real inflation
includes the cost of food and energy.

The Fed is also aware that housing costs account for 30% of the Consumer
Price Index, and that the method by which price increases in the housing
sector are measured also significantly understates inflation. Housing
inflation as calculated for the CPI is not based on changes in the price of
houses, but on changes in the cost of renting a house. Yet as home prices
have spiked up around the country, rental costs have remained flat. Renters
who could not previously afford a home of their own, have been increasingly
able to, thanks to low mortgage rates. But they leave vacant apartments and
houses behind for which there is obviously increasingly less demand. So, in
many areas of the country, while home prices have sky-rocketed, rental costs
have remained basically flat. For example, in some coastal areas in Florida
and California home prices have almost doubled over the last three years,
yet because housing inflation is measured by rental costs, the housing
component for those areas in the Consumer Price Index has remained almost
flat over the same period.

The Fed is well aware of this additional disconnect between reported
inflation, and actual inflation, and that it has more pressure from
inflationary forces to raise interest rates than it acknowledges.
Alan Greenspan made it clear again this week that more rate hikes lie ahead.
How many more? He’s not saying. About all the Fed has said is that rates are
still ‘too accommodative’, and need to be raised to a ‘more neutral’ level.
Economists have been guessing that a neutral level is probably around 4.0%.
Even after eight hikes over the last 12 months, the Fed Funds rate is only
up to 3%.

But, will even 4% be enough to bring inflation under control? The Fed Funds
rate over the last 15 years has averaged 5.25%, and in its rate hiking
cycles of the last 15 years the Fed did not stop until the rate was at least
5.5%.

I expect the Fed will stick with statements saying that inflation remains
under control, and will hike rates at only a ‘measured pace’ as long as it
can, which it hopes will not create panic. But higher rates for some time to
come seem already baked into the pie by inflationary forces that are being
covered up by faulty measurements and misleading statements.


Sy Harding is president of Asset Management Research Corp., DeLand, FL,
publisher of The Street Smart Report Online at www.streetsmartreport.com and
author of 1999’s Riding The Bear ­ How To Prosper In the Coming Bear Market.