Despite investor anxiety, history suggests the Federal Reserve will not launch a series of preemptive strikes against inflation and send interest rates significantly higher, according to a study by a bank economist.
The federal funds rate, adjusted for inflation, is already "hovering above its historic norm" after a pair of summer increases, noted Anthony Chan, chief economist at Bank One Investment Advisors Corp. in Columbus, Ohio. The Fed closely controls this rate to implement monetary policy.
Mr. Chan said the central bank may well notch up the funds rate one more time in November, but thereafter would almost certainly require clear and convincing evidence of accelerating inflation before doing more. A one-month spike in the producer price index or consumer price index would probably not be sufficient.
An end to the Fed's credit-tightening campaign would be good news indeed for bank stocks. They have been heavily battered, sliding 22% in overall value since the central bank's quarter-point rate hike on June 30.
"Much of the recent interest rate fear is driven by the fact that the federal funds rate tends to move steadily higher as economic expansions mature," Mr. Chan said. The current expansion has been underway for an extraordinary eight and a half years.
But right now the "real" funds rate is 3.15% -- the nominal 5.25% rate minus the year-over-year change in the consumer price index. Over the latest third of the current expansionary period, since early 1997, it has actually averaged an even higher 3.24%.
In fact, the real federal funds rate is now already as high as it was in early 1995, after the Fed had engaged in a yearlong credit-tightening exercise that doubled the nominal funds rate to 6%, from 3%.
The latest reading of the consumer price index is due today.
"Because the current numbers are already above historical trends, it does not appear that we are due for a surge in the federal funds rate in the near future," Mr. Chan said. Of course, if inflation does spike, the real rate would fall, signaling more rate hikes on the way from the central bank.
In the meantime, with real rates already high, the Fed may be relying more on talk than action -- an activity often referred to as "jawboning." Last week Fed Chairman Alan Greenspan cautioned again in a speech that investors may be underestimating risk factors in stock prices.
"The Fed would much prefer to talk down the stock market than raise rates in November or December," Edward Yardeni, chief economist at Deutsche Banc Alex. Brown in New York, told clients on Monday. A less bullish market would reduce inflation risks by dampening consumer confidence and therefore spending.
What does not seem to be in the cards is another episode like the 1994-95 rate-hike cycle, still fresh in the memory of bank stock investors. Those rate increases came after the Fed had aggressively poured money into the economy in the early 1990s -- so aggressively that the real funds rate was virtually zero until early 1994.
Mr. Chan said history confirms that the Fed "doesn't begin raising rates simply to end economic expansions," but becomes more active when inflation actually begins to jump. That has typically happened because productivity growth, the counterweight to inflation, has tended to weaken as economic upturns mature.
But not this time.
"Despite a pause in the second quarter of this year, productivity has failed to decline in the later stages of the current expansion and has instead exhibited signs of acceleration," the economist said.
Indeed, annual growth of nonfarm business productivity has exceeded 2% in two of the last years, while on the other side of the scale the consumer price inflation rate rose by a smaller 1.7% in 1997 and 1.6% in 1998. As long as this favorable combination continues, "the real and nominal federal funds rates can be expected to remain well below menacing levels," Mr. Chan said.