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How to see the inevitable rise in interest rates before it hits

February 4, 2010

Seven Signs of the End of Free Money

It’s important to remember that the Fed adjusts rates based on inflation expectations. And right now, there’s too much slack in the economy for inflation to be an immediate concern.

In fact, the United States hasn’t seen this much slack – the amount of actual GDP production versus the potential production if all economic resources were being employed – in over 25 years.

And that means the Fed won’t consider a rate hike until these three data points improve:

1. Unemployment: Needless to say, it’s uncomfortably high – and is a key contributor to economic slack at the moment. We’ll need to see a definitive return to growth here. (Remember, the economy added 4,000 jobs in November, only to lose 85,000 in December. And the latest ADP report suggests the losses carried over into January.) Once unemployment peaks, the Fed usually waits at least a year before raising rates.

2. Factory Utilization: If our factories aren’t running at full-tilt, there’s no way the economy is either. That’s the case now, with factory utilization near a record low of around 72%. In the last two decades, the Fed has waited to raise interest rates until factory utilization rebounded to around 80%, so we need to see significant improvement here.

3. Wages: Economic slack also shows up in wage growth. After all, when companies are ferociously cutting costs and employees are worried about simply having a job, raises are virtually non-existent. Given the severity of this downturn, it’s no surprise that wages fell at their fastest pace in 25 years. We need to see a pronounced rebound before the extra money in consumers’ hands prompts the Fed to increase its inflation expectations and, in turn, raise rates.

Watch What the Fed Does, Not What it Says

Beyond the economic data, we need to focus on the Fed’s actions. Every move is intentional, but the bankers don’t always call attention to them in their speeches. I’m convinced that the Fed must do the following before hiking rates:

4. End the Easing: The Fed introduced nearly half a dozen “special liquidity facilities” to navigate the financial crisis. Some included ridiculously cumbersome names like the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity-Facility.

So it only makes sense to unwind these facilities before tightening monetary policy. Four of them expired as planned on February 1. And the program aimed at purchasing $1.45 trillion in mortgage-backed securities will end in two phases – on March 31 and June 30. However, the Fed can extend these programs if necessary, so if it does, that pushes out the timeline for a rate hike.

5. Sop Up Extra Cash (temporarily): Before the Fed hikes rates, it will look to drain extra liquidity out of the system. So look for the bankers to use newly introduced term deposits and reverse repurchase agreements.

The first acts like a traditional certificate of deposit and encourages banks to keep their reserves on deposit rather than lending them out, which would accelerate inflation. The second involves the Fed selling securities from its portfolio with an agreement to buy them back later.

Keep in mind that these are temporary fixes, as the cash is ultimately returned. But the Fed will need to ramp up these special tools before hiking rates.

6. Sop Up Extra Cash (permanently): The amount of excess reserves in the banking system will also require the Fed to remove cash permanently. Expect the Fed to sell some of its long-term securities outright to accomplish this.

7. The Fed Changes Its Policy Statement: Each word in the Fed’s statement is chosen wisely. And at least a month in advance of raising rates, the Fed will need to strike one or two key phrases that have been mainstays throughout the crisis – “exceptionally low” and “extended period.”

In the end, my road map isn’t necessarily sequential. Nor do I think the Fed needs to follow it to the letter before raising rates. Economic conditions are fluid and therefore could prompt a swifter move.

That said, the more items you can tick off, the closer we’ll be to the most heavily anticipated rate hike in history. So start keeping track now.

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