U.S. rate hikes in 2010? Plausible, but not a given

WASHINGTON (Reuters) - Wall Street's raging bulls may be getting ahead of themselves.

From the first inklings of U.S. economic growth after the deepest recession since the 1930s, some investors have extrapolated a robust expansion that will force the U.S. Federal Reserve to raise interest rates in the second half of next year.

Their reasoning, based on the notion that companies overreacted to last year's epic financial meltdown by cutting staff and production too sharply, has some merit.

Yet judging from the core of the central bank's rate-setting Federal Open Market Committee, most prominently Chairman Ben Bernanke and his No. 2, Donald Kohn, policymakers are hardly trigger happy.

"Markets are focused on the global recovery, but they seem to be looking for clues in the wrong places," said T.J. Marta, strategist and founder of Marta on the Markets.

The Fed's two leading officials, the central bank's center of gravity, have focused almost exclusively on the risks to growth from a weak labor market and browbeaten banks.

Bernanke appears to think the economy will continue to operate below its full potential for a long time.

"The bulk of the evidence indicates that resource slack is now substantial," he wrote in a letter to a senator published last week, a reference to the nation's double-digit unemployment rate and spare industrial capacity.

Investors have downplayed this dovish tone, moving to price an interest rate increase by the third quarter into futures markets. A Reuters poll of top Wall Street banks last week found nine of 15 thought the first rate hike would be in place before 2010 draws to a close.

A robust minority, however, sees rates on hold for the foreseeable future. "The Fed will again make very few moves in 2010," said Douglas Porter, economist at BMO Capital Markets.

THE TOOLSHED

More eventful could be any effort, possible by late summer, to apply some of the alternate policy mechanisms the central bank has been developing in recent months to withdraw the extraordinary liquidity it has pumped into the banking system.

As the Fed has outlined, these might include reverse repurchase agreements in which the Fed could borrow back vast sums from banks, a term deposit facility to take money out of circulation, outright sales of assets the central bank has accumulated, or some combination thereof.

The outcome of any such initiatives could have a big impact on market perceptions of the Fed's ability to control the massive excess bank reserves it created to fight last year's global financial meltdown.

There is some risk, analysts say, that inflation expectations could become unmoored if one of the Fed's new levers failed to tighten financial conditions as advertised, raising broader doubts about the central bank's exit strategy.

Excess reserves now total a whopping $1.1 trillion. Before the crisis, they rarely exceeded $15 billion. Inflation hawks tend to see this rise as inherently inflationary, while monetary doves believe it is mostly harmless absent a surge in lending by banks, which remains all too elusive.

TIMING IT RIGHT

Not only did the Fed slash short-term rates close to zero a year ago, it also used unorthodox tools to push other borrowing costs lower, including through the purchase of more than $1.5 trillion in government bonds and mortgage-backed debt.

Now that the economy is growing again, speculation about when policymakers will pull out, and how rapidly they will do so, is in full swing. Better economic data has emboldened bulls to entertain the possibility that policy will be caught off guard by an unforeseen surge in growth.

But skeptics point out that most of the early growth signs in recent months can be traced to government-funded programs, like a tax credit for homebuyers, that will eventually wane.

"We suspect that a slowdown in economic growth next year will force the Fed to shelve those plans and leave rates on hold for much longer, possibly even until 2012," said Paul Ashworth of Capital Economics.

The political backdrop only reinforces that view. The American central bank, whose public approval ratings have taken a beating through the crisis, has come under increasing congressional scrutiny for failing to prevent the crisis. The Fed may be independent, but it is not altogether insulated from political pressure.

One factor that could force a change of heart at the central bank is a further sustained decline in the U.S. dollar.

In November, when the U.S. currency hit a 15-month low against a basket of major currencies, Bernanke openly expressed concern over the drop, an unusual move since Fed officials have historically deferred to the Treasury on exchange rate matters.

Since then, worsening conditions in Europe and better data domestically have stemmed the tide of dollar declines, earning the Fed some reprieve. But any breach below key levels -- say a breach of $1.60 to the euro from current levels around $1.43 -- would certainly grab the Fed chairman's attention.