HSBC Bank USA says that it has changed its economic and interest rate forecasts, and is now calling for the U.S. Federal Reserve to raise rates 200 basis points in next six to seven quarters, due to stronger employment and an up-tick in inflation.

“Our view was that Fed funds would not rise in 2004. Given recent economic developments, that now appears unlikely,” it says. “As a result, we have raised our Fed funds target for the end of 2004 to 1.75% from 1% and end-2005 to 3% from 2%. We have changed our end-2004 call for 10-year note yields to 5% (3.8% previously) and to 5.5% in 2005 (5% previously).”

“Our best guess right now is that the Fed will raise rates by 25 bps steps in August, November and December. It will then raise rates a further 50 bps in Q1 of 2005, 50 bps in Q1 2005 and a further 25 bps in Q3 2005, taking the funds rate to 3%,” it says. “Although pressure is building to hike at the next meeting on June 30, that is also the date of the Iraq sovereignty hand-over, and the prospect of heightened geo-political tension could keep the oil price at $40 or higher. If so, the Fed’s risk-management approach to policy may make an August hike more likely.”

“Overall, then, we look for 200 bps of tightening by the end of 2005 (was 100 bps), with 10-year notes rising 75 bps from current levels to 5.5% next year. Part of the reason that 10-year note yields do not need to rise as much as Fed funds from here is that financial markets have already priced the hikes in. The Fed has also carefully laid the groundwork for future rate hikes in a communication policy that is arguably being better managed than say in 1994,” it says.

“The main justifications for beginning the journey towards some neutral rate are a pick-up in employment and a pick-up in inflation, with a backdrop of strong aggregate demand growth and less excess capacity,” it says. “In addition, it appears some members of the FOMC may be concerned about excess liquidity going into asset markets, such as housing, even though other members, such as Greenspan, have tended to downplay the need for a direct link between monetary policy and asset markets.”

HSBC says this period of upcoming monetary tightening may be seen as one of the Fed’s more successful attempts in managing market expectations, and that the market will not be surprised like it was in 1994.

http://www.us.hsbc.com