Stephen King: The Fed's remorseless interest rate rise may continue, but all trends have their limits

My youngest daughter, Sophie, has been cultivating some Triops. These are little, rather unpleasant-looking, three-eyed aquatic animals who, as a species, have been on this planet for a good few hundred million years. You can buy a kit from the toy shop that gives you eggs, food and a small version of the underwater world created by the Bond villain Stromberg in The Spy Who Loved Me. You then watch the eggs hatch and the creatures grow. They eat anything. One of the ghoulish attractions for children is that Triops eat each other. In fact, Sophie now has only one, fat and presumably rather savage creature to cultivate. It eats fish and whatever other morsels that it can get its jaws around.

The big question Sophie has - and doesn't fully know the answer to as yet - is exactly how large this Triops will become. Will its tail start to swish, damaging the outer casing of its miniature Stromberg world? Will it begin to spread out over the desk in Sophie's bedroom? Will Sophie open a wardrobe door and find that the Triops has been making itself at home in her school uniform?

None of these scenarios is likely. According to the instructions that accompany the kit, Triops can grow to a length of three inches. They carry on swimming around for a bit longer, eating and pooing, and then keel over. Nevertheless, were Sophie to extrapolate her Triops' current rate of expansion, she would have difficulty ruling out the other, more disconcerting, scenarios: I suspect she's feeling nervous about her wardrobe, at least judging by the large number of clothes abandoned on the bedroom floor.

Sophie, though, is unlikely to engage in an extended exercise of extrapolation. She knows there are limits beyond which Triops will stop expanding. She's just not sure exactly what those limits are. But she can guess from the size of the Stromberg world, from the amount her pet is eating, and from the pictures on the box in which the kit came that her Triops is unlikely to expand much further. Put another way, Sophie knows persistent extrapolation is not the best way to make a forecast.

Financial markets, though, like extrapolations. These create the illusion for investors of predictable patterns. If markets go up one day, the hope is that further gains will come the next day. Why else would we have the language of "bull" and "bear" markets? If inflation starts to rise, people assume inflation is "taking off", that today's higher inflation rate inevitably means tomorrow's will be higher still. When interest rates rise, financial markets have difficulty in working out when they will eventually stop rising. In virtually all monetary tightening cycles, financial market expectations eventually "overshoot" the ultimate peak in interest rates.

One reason for this is the way in which policymakers sometimes set things up in predictable fashion. The US Federal Reserve, for example, has raised interest rates by 0.25 per cent at all its policy meetings since it started tightening monetary policy in the summer of 2004. The key Fed funds rate is up to 4 per cent and seemingly still rising remorselessly.

Financial markets think the Fed funds rate will peak somewhere in the range of 4.5 to 5 per cent. But what happens when we get to January and the Fed funds rate is, by then, up to 4.5 per cent? Will markets then begin to think the peak will be in the range of 5 to 5.5 per cent? And, if this logic continues, will rate increases ever end? There are eight Federal Open Markets Committee policy meetings in 2006 and eight in 2007. If we get a quarter-point increase in each one, as we've had so far, we'll end up with Fed funds up to 8.5 per cent by the end of 2007. By that time, Sophie's Triops will have escaped from her bedroom, left our house and will be slithering down the road, spitting out indigestible parts of cars, dogs and small children as it makes its way to the nearest river.

Extrapolation clearly has limits. At which point does the apparent trend begin to bend? Financial markets will soon have to grapple with this issue. And so will the Fed. Already, the Fed funds rate has gone up by 3 percentage points, a substantial act of monetary aggression set against Alan Greenspan's previous track record. A further 0.5 or 1 per cent would represent the biggest monetary tightening in the Greenspan era, a time characterised for the most part by ongoing price stability.

One possible explanation for this new-found aggression is that inflation is returning. A quick look at recent data suggests cause for concern. The left-hand chart suggests consumers have become alarmed about inflation in recent months, believing prices could be rising in six months at an annual rate of approaching 7 per cent.

How accurate is this fear likely to be? Past experience suggests the Fed can afford to remain relatively relaxed. Consumers' inflationary perceptions have been persistently higher than inflationary reality. And consumers' perceptions also depend critically on the oscillation of the headline inflation rate from one month to the next. A high monthly inflation number will raise consumers' expectations of future inflation whereas a low one will do the opposite. Consumers, if you like, are the worst extrapolators of short-term trends and provide no real clue as to the likely future direction of monetary policy.

Other measures of inflationary expectations are more reassuring. Using the price movements of Treasury Inflation-Protected Securitiesas a way of measuring inflationary fears within financial markets, there seems to have been little reaction to the rise in the overall inflation rate in recent months. On this measure, inflationary expectations are at their highest rate since before the Asian crisis in the late-1990s, but there's no sign of a sudden, and worrying, recent acceleration. The best that can be said is that financial markets believe the level of interest rates required to prevent inflation from heading upwards has risen from the lows seen in 2002 and 2003.

The absence of any sizeable rise in financial market measures of inflationary expectations, combined with a generally benign labour cost environment, suggests the rise in the US inflation rate in recent months will not persist. With oil prices lower now than at any point since Hurricane Katrina struck, there's the encouraging prospect of a rapid decline in headline US inflation in the months ahead. As the headline rate of inflation declines, and as consumers' fears of inflation fade, I suspect interest rate fears should also begin to subside.

In itself, this may not be good enough to allow the Fed to take a breather. It also has worries about the overheating US housing market. Nevertheless, it's at least possible to pick out conditions most likely to lead to a halt to monetary tightening in the US: a peak in headline inflation, an absence of sustained wage pressures, signs of a softening housing market and indications the household saving ratio is beginning to rise. Likewise, Sophie may be unsure about the ultimate size of her Triops but she already knows extrapolation of recent trends is not a rule guaranteed for ever to provide accurate results.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com