Public Forum: US interest rate outlook very difficult to call

Global stock markets have had a great run this year, better than many investors might have hoped for.

Part of that run has been based on expectations that the Federal Reserve was nearly done with the credit tightening campaign it began in June 2004.

But 'nearly done' has come to mean different things to different people. One more quarter-point interest rate hike? Two more? Three more? One more, then a pause, then maybe another hike in a couple months or a pause, then a rate cut?

The possibilities aren't exactly endless, but the debate has seemed so this year.

Now the Fed has gone to 5 per cent this week, it has raised the rate 4 percentage points since mid-2004.

That's a lot, which is why it's also reasonable to imagine policymakers wanting to pause. They know, as does Wall Street, that rate changes work with a lag: The effect on the economy shows up six to 12 months later.

The economy created a net 138,000 jobs in April, the smallest increase in six months. And the February and March job-growth totals were revised lower.

Although wages rose sharply, some analysts said that shouldn't stoke the Fed's inherent inflation paranoia.

Let's say Bernanke agrees that the April employment data shouldn't dissuade the Fed from pausing. How might investors react? Plenty of people have considerable paper profit in stocks this year. The Dow is up 8 per cent year to date.

But the prospect of an end to US interest-rate hikes isn't the only thing that has underpinned the market. The strength of the global economy and continued growth of corporate earnings also have kept people interested in equities.

Investors, for now, are back to believing in the Goldilocks economy: it won't be too hot, or too cold, but just right. And that may turn out to be on the mark.

Yet, it would be just like Wall Street, once the Fed paused, to suddenly begin wondering why they stopped. What do they know that we don't? As for bond investors, many of them last year had figured that as soon as the Fed stopped raising rates or even before that decision long-term interest rates would decline.

But the bond market has become a nervous place this year. For one thing, the economy has refused to roll over, the April employment data notwithstanding.

"Aside from the hurricane-induced weakness at the end of 2005, the pessimists have been consistently wrong about the strength and resiliency of the US economy," says Michael Darda, chief economist at investment firm MKM Partners in Greenwich, Conn.

He thinks the pessimists remain misguided and the Fed will face pressure to continue raising its key rate, ``ending the year closer to 6 per cent than 5 per cent.''

With the April wage inflation numbers and the continuing levitation of oil prices, bond investors have to wonder how much more inflation may be in the pipeline.

There's another issue for bond investors: Is it worth accepting a 5.09 per cent yield on a 10-year Treasury note if the Fed's short-term rate goes to 5 per cent and sits there? That isn't much of a rate differential.

Could the Fed be on the verge of another long period of holding short-term rates in a narrow range, as in the late 1990s?

In the near term, Bernanke sounds honest enough when he says the Fed, in deciding rates, will wait for ``information relevant to the outlook'' for the economy and inflation. What else can it do?

If it fears it's gone too far and that the heretofore resilient economy is heading south, the Fed's history suggests it won't hesitate to cut rates again. That is, policymakers will cut if they aren't also grappling with rising inflation.

Likewise, if economic growth stays strong and the inflation threat increases, odds are that 5 per cent won't be the final stop.