Since the previous edition of the Sterling Weekly, the Dow Jones Industrial Average rose 82.60 points to finish the week at 10,471.50 In looking at this week's upcoming economic calendar I noticed that we have the Producer Price Index 'PPI' and the Fed Open Market Committee on Tuesday, and the Consumer Price Index 'CPI' on Wednesday. It brought up thoughts of interest rates and inflation, with the big question being when will the Fed begin raising interest rates?
In thinking about that question and reading the year over year numbers for the previous PPI report I felt it was important to remember that starting in the 4th quarter of 2008 and continuing through the 2nd quarter of 2009 the economy and market contracted severely. Right now the trailing 12 month numbers look rather subdued due to the market contractions that occurred during the last quarter of 2008 and the 1st two quarters of 2009. However once we move through the 2nd quarter of 2010 the trailing 12 month comparisons could very easily start to show rising inflation numbers, prompting the Fed to raise rates. So we could start to see rising interest rates in late 2010 under that scenario.
The next question is once interest rates begin to rise, what effect with that have on the economy? Well, I can think of three (3) obvious answers. The 1st being that rising interest rates will hurt the housing market by reducing the affordability of the average house. The 2nd being that rising interest rates will slow the economy. That is an Econ 101 given fact. The 3rd being that rising interest rates will increase the interest rate on the Federal Debt, that will further increase the Federal Deficit, further putting pressure on the US's credit rating.
Can the Fed resist increasing interest rates? While there is surely a lot of debate on that last question, in the longer term the market sets the rates. What about in the shorter term? My thoughts are that as the other industrialized nations see their economies recover their rates will rise and those competitive pressures in the international finance markets will ultimately cause our rates to rise. When will this happen?? I am not sure, but my guess would be in 24 months or less. How high could our interest rates rise? Well, I would not be surprised to see the Fed Funds Rate rise to the 3% level by the end of 2010, and that is assuming inflation remains tame. If inflation jumps to the 6-8% range then we could Fed Funds in the 7.25% to the 9.25% range.