Economic Forecast: Interest Rates to Move Slowly Upward
Real gross domestic product (GDP) continues to grow at above-trend rates. On June 25, the Commerce Department revised its estimate of annualized first-quarter growth in real GDP from 4.4% to 3.9%, but that pace still is above the sustainable long-term trend for the U.S. economy. For the most part, the downward revision reflected weaker non-farm inventory investment and a larger trade deficit. The composition of the “final” GDP report actually bodes well for the balance of the year, and NAHB’s forecast shows an average growth rate of 4.3% over the next three quarters.

The inflation plot is thickening as the economy moves forward, however. Indeed, we’re now faced with an issue typical of most economic expansions in the past, i.e., rising inflation that could take a serious toll on the economy over time. In response, the Federal Reserve hiked short-term interest rates at the conclusion of its Federal Open Market Committee (FOMC) meeting on June 30 — raising the federal funds rate target from 1% to 1.25%, as expected. That was the first rate increase since May 16, 2000, when an inflation-wary Fed moved the funds rate up to 6.5%.

The June 30 increase is only the first step in what is likely to be a persistent march by the Fed back to monetary “neutrality,” which probably involves a real (inflation-adjusted) funds rate of 2% to 2.5%, and a nominal rate of at least 4%. Financial markets seem to be expecting quarter-point hikes at most FOMC meetings between now and the end of 2005, and NAHB’s forecast shows the funds rate at 2% and 4% at the ends of 2004 and 2005, respectively.

Unlike some past periods, in this cycle the Fed has been giving advance notice of its intentions. As a result, long-term interest rates moved up in advance of the June 30 FOMC meeting, and the upward adjustment to the federal funds rate seemed to have little net effect on the bond market. The process of monetary tightening that lies ahead presumably will involve some further upward pressure on long-term rates, even though the policy has been widely anticipated and is designed to contain inflation. NAHB’s forecast currently shows increases of about 125 basis points in long-term bond rates between mid-2004 and late 2005, but that's less than half the projected increase in the federal funds rate. [ return to top ]