On May 16 the Federal Reserve continued its
search and destroy mission to stamp out potential
inflation threats and bring the US economic
growth rate down to safe levels. But the Fed did not
advance at the same pace of raising interest rates since it
began in June 1999. After five previous increases, the federal
funds rate was jacked up 50 basis points, the highest
leap in five years, reaching 6.5%. The last time the federal
funds rate hit 6.5% was when the US economy was
climbing out of a recession in 1991.
The Fed’s move helped fuel a
continuation of volatility on
US equity markets that began
in early spring. “The markets
are focusing on macroeconomic
issues instead of earnings,”
says Jon Olesky, head
of block trading at Morgan
Stanley Dean Witter. “The
debate continues as to how
long the Fed will keep raising
interest rates. Volatility will
remain high until the next
meeting in June and may
continue to the end of the
year.” In fear of rate hikes
slowing the economy and
tech equities viewed as overvalued,
the NASDAQ composite
has fallen over 32% from its
mid-March high operating
in a deep bear market – with a
16.7% decline this year.
From its high in January,
the Dow Jones
Industrial Average
has dropped 9.4%, off
7.6% for the year.
A major concern
among investors is
when the Fed will
stop the tightening
cycle. According to
Maury Harris, chief
economist at PaineWebber, the Fed is keeping a close eye on the labor market. “We have a very
tight labor market, and wages are going up a lot,” says Harris.
“There will be another hike in June.”
Recently, unemployment fell to a 30-year low at 3.9%. In
the first quarter the employment cost index rose 1.4%, the
largest gain since the third quarter in 1989. In April average
hourly earnings went up 6 cents, a 0.4% increase, which was
more than the 0.3% rise in March. On top of those pressures,
the US trade deficit continued to grow in March, up to $30.3
billion, which shows strong consumer demand pulling in
imports. In the last six months, the annual rate of core inflation
rose to 2.5%, up from 1.9% in the previous six months.
Some hold that the end of the tightening cycle is near.
“There is no evidence of true inflation in the US economy,”
argues Bruce Steinberg, chief economist at Merrill Lynch.
“I expect interest rates to reach 6.75% to 7%, but no further.”
He says that home sales have gone down by 10% in the last
nine months, while retail sales fell 0.2% in April. The consumer
price index (CPI) was flat in April and the core CPI
-excluding food and energy prices – increased only 0.2%,
half the rise in March. The producer price index in April fell
0.3%, the first decline in 14 months.
Steinberg expects economic growth to slow from 6% over
the last three quarters to 4.5% in the second quarter and ease
into 3.5% in 2001. If the cycle ends after one of the Fed meetings
in June or August, bet on double-digit returns on equities
in the coming year as investors expect rate decreases and
earnings moving up, says Steinberg.
Volatility on NASDAQ, moving up or down by 1% to 4% in a
day, is routine. If investors can stomach the rocky ride, the end
of the tightening cycle may be worth the wait. But with the labor
market getting tighter, when it comes is debatable
