Predicting the Fed's Next Move

The Federal Reserve didn't pull out any surprises today when it blandly announced that it will keep interest rates near zero as the economy continues to recover. But even as the Fed remains fairly tight-lipped about when it will begin ratcheting up rates, economists have been quick to speculate about what's in store. Here are some predictions:

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Timing. The general consensus is that the Fed could raise rates as early as this summer. But to some, this view appears overly optimistic. "The consensus view of what the Fed's likely to do makes absolutely no sense," says Michael Darda, the chief economist for MKM Partners. "I think the very earliest would be the fall or winter of this year, and I wouldn't be surprised to not see the Fed do anything until early 2011."

The World Bank recently estimated that the U.S. economy will grow by 2.5 percent this year. Darda predicts 4 percent growth, but even then, he says, the economy won't be prepared for an interest rate hike by summertime. Meanwhile, if economy remains sluggish, the Fed could keep rates down until 2012. "If it turns out the recovery disappoints, the Fed won't be raising rates. Period," he says.

Michael Englund, the chief economist for Action Economics, says that in a vacuum, the Fed should be ready to fix the interest rate at 25 basis points by June or July. But given the dicey political climate, he expects that any decisions will likely be postponed. "Our call at this point is going to be after the November elections," he says. "Not at the November meeting, which is [right] after, [because that] would look excessively political, but probably at the December meeting."

Jeff Tjornehoj, Lipper's research manager for the United States and Canada, says the Fed could wait until 2011. "I would figure it's going to be late 2010 or early 2011," he says. "If the administration tilts its focus toward job creation, I think what people will be concerned about is that raising interest rates too soon could halt job-growth prospects."

Complicating factors. The precise timing of the Fed's eventual increase, of course, depends on how a number of moving parts eventually fit together. The two most obvious questions are when the lending environment will improve and how long it will take for unemployment rates to come down. "Those are really the two tipping points for the Fed in my view: a sustained turn in the labor market and a recovery in bank lending. We'd have to see those two things before the Fed raises," says Darda.

Also thrown into the mix is the populist undertones that President Obama and Congress have recently infused into their policies. These new dynamics could change how Federal Reserve Chairman Ben Bernanke chooses to proceed. "The real dynamic here is that Congress seems to be willing to make Bernanke part of the scapegoating process. They seem to want to make the Fed the villain going into the November elections," says Englund. "I think that backdrop makes it difficult for the Fed to argue why it's tightening policy at a time when the public is perceiving an economic downturn as being its primary focus."

So what would it take for the Fed to hasten its timeline? "If we went from 10 to seven in a matter of months, I think that would be the kind of acceleration where people would say, 'We need to have a handle on this,'" says Tjornehoj, referring to the country's unemployment rate. "I don't think that's within the realm of likely possibilities."

Speed. One key question is: When the Fed decides to push up interest rates, how quickly will it move? Tjornehoj predicts that the Fed will adopt gradual increases of a 25 basis points at a time. "I think the first indication will be changing from a range of zero to 25 to simply pegging it at 25. And then the next one would be 50," he says. "I think it's going to be a slow progression up to 1 percent."

Englund agrees. "We're assuming a quarter point a meeting, just because that's the Fed's historic norm and because we think they'll be walking on eggshells when they start the tightening process," he says. Still, he argues that a more compact timeline would be ideal. "The smart thing, I think, would be to get the rate to 2 to 3 percent as soon as possible," he says.