Economic & Business Focus: Reading Interest Rate Vital Signs

CFOs can monitor the forces that will support gradual rate changes and watch for developments that might signal sudden hikes.

Interest rates are the sharpest tool in the shed for controlling economic growth and spending. The Federal Reserve would like to maintain its current commitment to a series of modest interest rate increases designed to hold inflation in check through 2005, but its policy will be shaped by external forces that are growing increasingly clamorous. The real question is whether foreign governments will withdraw their funding for the enormous U.S. current account deficit and force the Fed to raise rates sharply to hold on to foreign investors. With almost half the cumulative current account deficit now financed by foreign governments, U.S. interest rates will be heavily influenced by decisions made well beyond U.S. borders.

At the macro level, the first casualty of substantially higher rates will be the housing industry, which has fueled much of the recovery. "The housing sector is very interest-rate sensitive," notes Frank E. Nothaft, vice president and chief economist with Freddie Mac in McLean, Va. "Higher rates will reduce overall housing construction and home sales levels." Higher rates will also kill the financing deals that have kept U.S. automakers afloat and the consumer goods sectors that have been propped up by record-high levels of consumer debt. CFOs will have to monitor at least half a dozen different factors to form accurate predictions of where rates are headed.

Rates for 2005

The Fed prefers to avoid large rate changes. "Current rates are near historical lows, and inflation is very low and under control, so there is no reason to believe that a large run-up in interest rates will occur," says Christopher Waller, professor of economics and econometrics and the Schaefer chair of economics at the University of Notre Dame in South Bend, Ind. "It is very unlikely that rates would be more than one percentage point higher by the end of the year. Even the recent jump in oil prices will most likely not elicit much pressure from the Fed to raise rates to head off inflation."

Dorsey D. Farr, senior economist and director of asset allocation for Wilmington Trust, a personal trust provider in Wilmington, Del., sees the Fed moving rates to 2.5 percent before midyear and 3 percent by year-end. "This monetary policy is appropriate given the backdrop of strong productivity growth and the current inflation expectations. We also expect that long-term rates will increase, although likely by a smaller amount than short-term rates."

James M. Brown, senior vice president and senior portfolio manager at the Compass Bank Wealth Management Group in Austin, Texas, expects the federal funds rate to reach 4 percent by the end of 2005, assuming that growth is solid, the labor market is healthy and the core inflation rate rises gradually. "We anticipate that the Fed will continue to take a measured pace on interest rates throughout 2005, as oil prices and rising interest rates slow GDP from a projected 3 percent in the fourth quarter of 2004 to approximately 2.5 percent in 2005," he says.