Prudential Strategist Argues for Moderation by Fed in Raising Interest Rates

By Randy Myers

With the worst of the financial crisis apparently behind us, the Federal Reserve may try to push interest rates higher toward the end of this year, says Robert Tipp, chief investment strategist for Prudential Insurance Co.’s Prudential Fixed Income unit. But he wouldn’t advise it. A more prudent course, he argues, would be to wait at least until the middle of next year before contemplating any tightening of rates, giving the U.S. economy more time to reach what he calls “a profile of rip-roaring growth.”

Although the economy has certainly improved over the past several quarters, Tipp told participants at the SVIA’s 2010 Spring Seminar that it still has a long way to go before unemployment levels get back to acceptable levels. Demand for credit remains low too, he said, mitigating the need for higher rates to head off overspending by the public.

Continued fragility in the real estate market also argues against a rising rate environment, Tipp said. Delinquency rates on both residential and commercial mortgages continued to climb at a dramatic rate through the end of 2009, he noted, and to the extent that leads to further weakening of the real estate market it will prove a drag on the economy.

Besides, Tipp said, interest rates already have climbed dramatically since the depth of the financial crisis, with yields on the 10-year Treasury bond near 4 percent in early April versus about 2 percent in December 2008.

An environment of rising inflation could always tilt the Federal Reserve toward higher interest rates, but Tipp said that with modest demand for credit, continued high unemployment rates and a fragile real estate market, the Fed may be worried as much if not more about the potential for deflation right now, rather than inflation. And in fact, he noted, core inflation rates remain low at the moment.

While promoting a cautious approach to raising interest rates, Tipp also argued that the U.S. economy is in better shape than many pundits think, which could eventually lead to a rising interest rate environment. For example, he said, U.S. GDP should grow at about a 3.2 percent rate this year and a 2.8 percent rate in 2011, outperforming both the Euro zone and Japan, with inflation staying well under control.

While the federal budget deficit has soared since the onset of the financial crisis, he noted, the Congressional Budget Office currently projects that it will shrink dramatically as a percentage of GDP over the next four years, from over 9 percent this year to about 2.6 percent in 2014. “I know we feel bad about our debt load, but we’re better off than the European Union and Japan,” Tipp said. “It’s also important to remember as we look at those budget deficit numbers that part of that was intentional. We were in a recession and a couple of wars. When the deficit has climbed in the past, people projected that it would remain that way, but it didn’t. We heard the same talk in the Reagan years, but it didn’t happen. The system turns out to be better than we

think, the economy performs better than expected, the numbers improve, and once again disaster is averted.”

While the U.S. does look to be in bad shape in view of its unfunded state pension liabilities, budget deficits and demographic Social Security and Medicare problems, Tipp observed, Europe suffers from all of those problems to at least the same degree, if not more so. “They have a more rapidly aging population,” he said, “and less money set aside for pension obligations than we do.”

Still, Tipp concluded, the U.S. economy has a lot of slack in it, and given the downside risks it is facing he does think the Fed will move slowly in pushing interest rates higher.