Fed rate action commentary from Swiss Re US chief economist

29 June 2006, New York

After today's 25 basis point Federal Reserve increase in the target fed funds rate to 5.25 percent, Swiss Re's US chief economist, Kurt Karl, commented, "Inflation concerns are forcing the Fed to continue raising interest rates — another 25 basis point hike in August is likely. The economy is growing at a solid pace, close to trend where the Fed would like to see it. However, with the unemployment rate falling, capacity utilization rising, high oil prices and a weak dollar, core inflation has been rising. The Fed needs to act now to avoid larger inflationary problems later.

"Our latest US outlook is for growth of 3 percent for the second half of 2006 and for all of 2007. Oil prices are expected to remain between $65 bbl and $75 bbl through the end of next year. Core inflation is projected to rise to 2.5 percent year-over-year within the next few months, then fall back to close to 2.0 percent next year, allowing the Fed to ease back to 5.0 percent on the federal funds rate. The Fed is comfortable when the federal funds rate is about 300 basis points above core CPI inflation. The yield on the 10-year Treasury note will rise along with the Fed's tightening. Next year, however, when the Fed eases, its yield is likely to remain close to 5.5% as the major, non-US central banks continue to tighten. Foreign tightening will help to push up foreign long-term interest rates, providing some competition for Treasuries," Karl said.

"Globally, growth is solid or improving in all the major regions. Hence, the large central banks are expected to continue tightening monetary policy. The European Central Bank will raise its policy rate to 3 percent or higher this year. Soon, the Bank of Japan will also begin to raise rates and China is expected to continue tightening modestly via an appreciation of the renminbi. These tightenings will cause long-term interest rates to rise further, pushing, for example, the yield on the Euro 10-year bonds to 4.2 and the Japanese government bond to 2.2 percent or higher by end-2006," added Karl.

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