Are the Fed?s growth concerns overdone?

The Federal Reserve raised the overnight federal funds rate to 4% this week. There are some interesting clues as to where the rates are headed. In my view, the rates are headed towards 4.5%, at the minimum, in the next two meetings. There are three main reasons why this should be so.

One, the Fed refers to the impact on output and employment from the hurricanes. In other words, even if the October employment report, due on Friday, were to be weaker, the Fed had taken that into account already. So, do not expect that to alter the trajectory of the rate cycle.

Two, the Federal Reserve alludes to the rebuilding of the Gulf region as providing support to economic activity. The Fed has, thus, signalled that it is concerned at both, the additional stimulus such reconstruction entails and the ongoing fiscal deterioration in the United States in the current fiscal year, 2005-06.

Three, the Federal Reserve did not take cognisance of the soft personal spending figures for August and September. It is clearly focused on stronger rather than weaker economic data and nascent inflation worries.

All of the above point to the federal funds rate being raised to 4.25% in December and to 4.5% in January. Consequently, the 10-year US treasury yield has not yet peaked for the cycle.

We very much doubt if the Federal Reserve would contemplate pushing the rate higher by 50 basis points in January. Concerns about the potential impact of such a move on consumer confidence, spending and the housing market and on any financial institution, coupled with relatively well-behaved inflation (at the core level), would ensure that such a move is both unlikely and unnecessary.

Indeed, data released on Thursday on non-farm productivity and unit labour costs in the third quarter suggest that the US economy would continue to defy sceptics and would reward outgoing Federal Reserve chairman Alan Greenspan with a positive combination of solid growth with moderate inflation. Labour productivity was strongly up at 4.1% in the third quarter and unit labour costs edged down.

The US dollar, despite the popular perception of strength, traded within a narrow range in October against most currencies, except the yen. Indeed, the euro has remained in a 1.20-1.24 range since the end of June. Just as the fixed income market was sceptical of US economic strength in the first half, the foreign exchange market is sceptical of US economic resilience, in the light of all the natural and manmade disasters in that country. Hence, the US dollar has not really made much headway on its own against most currencies, with the exception of yen.

While the weakness of the yen could be attributed to re-emergence of the ?carry-trade? (investors borrowing in lower interest rate currency and investing in higher interest-bearing currency), other Asian currencies are weak for a valid reason. Asian economic strength is more hyped than real.

The real question is whether the dollar begins to reflect the superior US economic fundamentals, relative to the eurozone, in the remaining months of 2005 and into 2006. There are enough compelling arguments to make for and against the US dollar. We fall in the camp of optimists, in general. If the Fed succeeds in slowing the US consumer (its real, but unstated, mission), then the resulting improvement in the current account deficit would be considerable. That is how it played out in 2001.

In that year, US consumer spending slowed and the current deficit shrank by nearly 1% of GDP. And, more important, despite the fact that the federal funds rate in the US came down drastically, from 6% to 1.75%, the US dollar gained against the euro. The market correctly judged that other economies would be worse off. Therefore, it is well possible that a similar play is re-enacted in 2006 and the euro really hurtles down to parity, rather than recover to 1.30-1.40. Whereas the whole world is obsessed with predicting the end of the US hegemony in many respects, the real negative action could happen in the euroland.

On the other hand, the US dollar could come under pressure if the political woes of the Bush administration render it wholly lame-duck. It already is largely one. Even the threat of impeachment cannot be ruled out. And Ben Bernanke, Mr Greenspan?s named successor, might be tested by providence right at the beginning with some crisis, financial or real.

If pushed to make a choice between the two scenarios above, I would still lean towards a ?euroland crisis? rather than a ?US crisis? forecast. If not for any other reason, than the one that most seem to be smacking their lips in anticipation of the latter and rarely discuss the risks of the former.

The writer is founder-director of LIBRAN Asset Management (Pte) Ltd in Singapore. The views are personal.