The Chance Of A Third Hike?

That may depend on how overseas economies are doing

To hike or not to hike? After two quarter-point rate increases since June, Federal Reserve Chairman Alan Greenspan must decide whether the 50 basis points will be enough to "markedly diminish the risk of rising inflation going forward"--the Fed's stated goal for the Aug. 24 hike. Or will a third hike be needed when the Federal Open Market Committee meets again on Oct. 5?

This was the big question Greenspan was pondering as he headed to Jackson Hole, Wyo., for the annual "Fed Camp" retreat. At last year's confab, Greenspan and other bankers saw pretty much the same forces in the U.S. that are igniting inflation fears today: tight labor markets, rapid growth and a swelling trade deficit. But back then, they also saw growing problems overseas. Russia had just defaulted on its debt, Asia was reeling, and the liquidity crisis was spreading to Latin America. Within weeks, the Fed was no longer thinking about rate hikes to cool an overheated U.S. economy; rather, it was pondering rate cuts to stimulate U.S. growth and fend off global recession.

Events overseas are also looming large this August--but for different reasons. The recovery in Asia and the strengthening in Europe have already made it safe for the Fed to hike rates without fear of plunging the rest of the world into recession. At the same time, those economies' relative strengths have been weakening the dollar. If U.S. consumption persists at current levels, that could not only send the trade deficit to new highs, but it could also set a little fire under inflation as consumers pay more for all those imports. That might tip the scale toward a third hike.

Last year, the dollar was rising against most major currencies, making all imports cheaper. And, the deflationary pressure that the global financial crisis placed on commodities helped keep U.S. inflation down even as labor costs rose. As Asia and Europe weakened, U.S. import prices fell 6.1%. The Goldman Sachs Commodity Index fell 39%.

This summer, those forces began reversing, to the Fed's dismay. As Greenspan put it to Congress on July 22: "Improving global prospects...mean that the U.S. economy will no longer be experiencing declines in basic commodity and import prices that held down inflation in recent years." San Francisco Fed President Robert T. Parry echoed the chairman in an Aug. 11 speech: "When we combine strong domestic demand with a pickup in demand from recovering economies abroad, the risk of inflationary pressures begins to build."

Fueling that concern is the speed at which some regions are rebounding. On Aug. 13, Japan reported a torrid 8.1% annual growth rate in the first quarter. And Germany's Bundesbank said on Aug. 24 that growth in the 11 countries in the euro zone "will probably only get stronger" this year. True, the world is still awash in production capacity. And parts of Latin America--especially Ecuador--look shaky. But "the world economy is bouncing back more strongly than people expected," says Fed watcher David M. Jones of Aubrey G. Lanston & Co.

What will the Fed watch before the October meeting? As always, it must focus on such domestic indicators as labor-market conditions and consumer demand. But a key gauge of just how fast things are moving overseas will be Japan's second-quarter growth rate, expected before mid-September. Fed insiders wonder if seasonal factors inflated the first-quarter figures. Come October, Greenspan may be just as anxiously awaiting news on retail sales in Tokyo and jobs in Paris as on growth in the U.S.

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