Federal Reserve Forum

Interest Rate Hikes, When Will They Stop?
The Federal Reserve has met twice since my last newsletter. After the May 10th meeting, Ben utters the dreaded “inflation” word causing the stock markets to sell off in lock step. Then in June, Ben says, “the moderation in the growth of aggregate demand should help to limit inflation pressures over time”. In other words, the interest rate increases are working. No kidding but when will it stop?

These most recent Fed comments revealed the first hint that we may be nearing the end of the Federal Reserve’s 17 consecutive 1/4 point interest rate increases. (In case you’re wondering, 17 quarter points is 4.25%) For the first time since it began raising rates from a low of 1%, in June of 2004, the Fed didn’t explicitly say another rate increase was under consideration. Currently, the futures market has priced in a 63% chance of a rate hike to 5.5% in August. This would give us a prime rate of 8.5%.

This is 50 basis points below the previous peak Mr. Greenspan set in 2000. In the mean time, the Fed will continue to read the economic tea leaves over the next 45 days. The Bank of Japan and the European Central Bank are set to raise rates in the next thirty days.

How might the current series of rate increases affect you? First, if you’re in the market for a new home or need to refinance, mortgage rates for fixed rate loans should reach 7% in 2007. If you have a home equity loan tied to the prime rate, your interest rate will more than double to somewhere around 8.5%. The popular interest only ARM loans will also double in rate just when the housing market has stalled. This may make it difficult to refinance when homes have not appreciated or may have even dropped. The overall impact here may be a loss of value in residential real estate between 10% and 20% from the 2005 peak. Combine this with the increases in gas and other raw materials and you may get a recession in late 2007. However, as with all recessions, we will not know until we have been in one for at least 6 months!

Is there a silver lining? Sure, six month CDS are now paying over 5.5%, nearly 4 times their low back in 2003! Also, market slowdowns generally create great buying opportunities. Remember, the economy works in cycles and we are about five years into the current economic cycle.