The First Leg Falls, So They Think

By the time you are reading today’s PROFIT CONFIDENTIAL, the news of the Fed’s rate increase will already be old news. In fact, it was likely the most anticipated Fed rate move in recent memory.

So the first leg has dropped, or has it?

Many market watchers are predicting continued higher rates. TD Bank economists, who are usually very conservative, expect the Fed to raise rates by another three-quarter percentage points this year and another full two percentage points in 2005.

Hence, the bank is predicting that the Fed’s key interest rate, by the end of 2005, will be 4% compared to only 1% just a few days ago.

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Well here’s what I think: If interest rates do rise at the pace TD Bank economists and many other analysts are predicting, the housing bubble will burst big-time, stocks will crash, and the economy will go into a tailspin. That’s why I don’t expect rates to move up all that much.

Debt-service ratios are at record highs. Thus, interest rate hikes in the months ahead will pack a much bigger punch for consumers than they would have just a few years ago. Greenspan is in a tight spot.

The Fed Chairman does not want the embarrassment of having to lower rates once he raises them, but that is exactly what Greenspan will have to do if higher interest rates have too much of a negative psychological impact on consumers.

In keeping interest rates at a 46-year low, Greenspan has done a great job in keeping deflation out of this economic cycle. While the Fed won’t talk about it, my readers are well aware of my concern for deflation. By keeping rates low and consumers spending, especially on housing, Greenspan has fought the fight against deflation quite well.

But in doing so, Greenspan has also created a few bubbles, namely real estate and debt bubbles-and they won’t be a pretty sight when they finally burst.

In keeping rates so unusually low, Greenspan has also managed to fend off the natural forces of a bear market in stocks. Unfortunately, the Fed Chairman has placed us in a very awkward position: Raise rates too much and the stock and real estate markets will come down. Keep interest rates at their 46- year low and consumers will borrow themselves into oblivion, creating even bigger bubbles.

He’s damned if he does, damned if he doesn’t. And that’s why I expect Greenspan to do a lot less in terms of higher rates than most economists and analysts are predicting.