If Yogi Berra were a finance analyst and still alive he'd say it was d & #233;j & #341; vu all over again.
Sophisticated investors and savvy business executives seeking barometers of today's economic climate would do well to look back to 1994 the last period when the Federal Reserve tightened interest rates to keep inflation at bay. Twelve years ago, the Fed hiked interest rates by 300 basis points, or 3 percent, in just one year. The Fed tightening came at a time when inflation was largely in check, as it appears to be today, ranging from 2.5 percent to 3 percent or slightly higher. As it was in '94, the prospect of interest rate increases is enough to send the stock market into a tailspin. Periods of rate tightening cause unease among investors in anticipation of an economic slowdown.
But some economists say that by moving quickly and early on interest rates, the Fed will have less work to do in the long run.
"Both cycles of rate increases were followed by relatively mild recessions," said Rodney Olea, director of fixed income at City National Asset Management, a unit of City National Corp. "These are different times but it's really the same themes."
Olea believes the U.S. currently is in a "normal economic cycle," and that Federal Reserve Chairman Ben Bernanke simply wants to slow the economy before rapid inflation sets in and becomes too unwieldy to control.
The same was true more than a decade ago.
Back then, the U.S. economy was reeling from the aftershocks of the savings and loan crisis, a severe slowdown in the defense industry and a crimped housing market. Today, a massive run-up in housing prices, a severe slowdown in technology stocks and sky-high energy prices are taking center stage. There is political uncertainty caused by the war in Iraq and labor markets have recovered enough that workers are starting to command higher salaries, another inflationary signal.
"There's an old saying that expansions don't die of old age, they have to be killed," Olea said. "The Fed will most likely not stop raising rates until inflation shows signs of slowing or something breaks in the economy."
Of course, several negatives were at work in the economy in 1994 that have no recent correlation yet.
Political shocks forced the Mexican government to devalue the peso, sending inflation soaring for the U.S.'s biggest trading partner. In Orange County, treasurer Bob Citron made the mistake of using exotic financial instruments to place bets on interest rates falling, rather than rising. That misadventure forced the county into bankruptcy, causing further jitters among investors.
The main difference between then and now is that the Fed raised rates seven times in the 1994 period to keep inflation in check, with most of the moves ranging from 50- to 75-basis point increments, or less than 1 percent. The current Fed appears content to raise the federal funds rate target in small, 25-basis point increments. (Basis points are often used to measure changes in or differences between yields on fixed income securities, since these often change by very small amounts.)
Some market watchers have expressed dismay that Bernanke has advocated using economic data about inflation to determine whether or not rates need to be increased again. Measured broadly, the swift market reaction that sent most stock market indices into negative territory in past weeks nearly preordained that the Fed could tighten too much for too long.
"I don't remember a time when the Fed threw out so much rhetoric and painted itself into a corner like this," said Donald Straszheim, vice chairman of Roth Capital Partners. "The unfortunate thing is that Bernanke and the Fed know that monetary policy works with a lag time, but somehow this got caught in the miscommunication."
Typically, the average lag time between Fed policy and rate shifts having any effect is roughly 10 months, though it can range from a year to 15 months. If interest rates are kept unchanged at 5 percent, Bernanke could inadvertently be strengthening the rate of growth in the money supply, setting the stage for a period of high inflation in the future.
And that would really be d & #233;j & #341; vu.
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