Asia's Woes Make Fed Rate Hike A Long Shot

With Asia in turmoil, the Federal Reserve is unlikely to raise interest rates at its meeting Tuesday, most market observers said.

"The risks are simply too big compared to the potential benefits," said Ian Shepherdson, the chief economist at HSBC Securities, New York.

For over a year-rates were last notched up in March 1997-Fed policymakers have opted for the sidelines, first on scant evidence of inflation and then to avoid complicating Asia's currency and financial debacle.

But with the U.S. economy strong, labor markets tight, and the stock market still sizzling, the central bank is facing a growing dilemma.

No rise in rates would generally be good news for banks. That is because the cost of funds for many banks rises faster than the yields on assets when rates rise.

A quarter-point hike in rates would "reduce inflation pressure marginally," Mr. Shepherdson said, "but might also induce another meltdown in Asia and place in jeopardy the entire world financial system."

As for stocks, the market dropped about 10% after the Fed last raised rates, in March 1997, recalled Sung Won Sohn, chief economist at Norwest Corp., Minneapolis. "The stock market is more overvalued today than it was then, so the reaction would be more severe now," he said.

He also cautioned about what he called the "asymmetry of the wealth effect" generated by the huge bull market in stocks. About 40% of Americans now own stocks, far more than when the market plunged in 1987, he noted.

"If market truly begins sliding, many inexperienced investors could stampede to get out," magnifying the decline.

"That happened in Japan," when that country's overheated market cracked nearly a decade ago, he said. Japanese stock values have since plummeted by two-thirds as the nation has struggled to reignite economic growth.

Luckily for Fed officials, inflation remains subdued, and most economists think the central bank can opt not to risk an averse reaction, at least for the moment.

Notably, Fed Chairman Alan Greenspan has issued none of the customarily vague warnings that have preceded other rate moves.

In a Dow Jones-CNBC poll last week, 33 of 35 economists for primary dealers in Treasury securities said they felt the Fed will not raise rates on Tuesday. But they also saw no real signs of a slowdown in the economy and expect the Fed's next rate move to be to up.

"No change in policy is expected Tuesday, but a sharply split Federal Open Market Committee may produce a contentious meeting," said Allen Sinai of Primark Decision Economics, New York. Still, he said, the odds of a Fed tightening this year remain at 40%.

In essence, the Fed is still awaiting the delayed impact of the Asian financial crises. How long it will wait is the real question.

"Asia was supposed to be a major catalyst for a slowdown, but thus far there is scant evidence of this," Mr. Sohn said. Instead, the mild winter and "a gusher of domestic demand" have kept the economy steaming.

The Norwest economist warned that "the Asian typhoon has not gotten lost in the middle of the Pacific." When it finally does arrive, "a deteriorating trade balance, an inventory overhang, and a softening housing market" will definitely cool the economy.

But that would come later this year, which may be too late for the Fed's comfort. Mr. Sohn thinks the Fed may feel compelled to raise rates this summer, perhaps in early July. The prospect worries Mr. Shepherdson and some others.

Lacy Hunt, a partner in Hoisington Management, Austin, Tex., said a Fed hike to stave off inflation is unnecessary because the spillover of Asian economic woes will do the job.

"It would be a terrible mistake to conclude that the effects of the Asian situation have even reached us yet in any significant way, and conditions there are deteriorating there very badly," Mr. Hunt said.

Nor do conditions here warrant a hike, he added. "There is no inflationary thrust, although unemployment is low."

Moreover, the Fed "has to consider the global ramifications of a tightening," Mr. Hunt said. A U.S. rate hike would further strengthen the dollar in foreign exchange, he noted, depressing weaker currencies and thus aggravating problems in Asia.

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