Fed rates to rise, but how much?

US interest rates need to go up but how far and how fast depends heavily on what assumptions are made about measures of slack in the economy, the Federal Reserve Bank of Dallas said on Thursday.
"Short-term interest rates will have to rise substantially at some point.
The interest question isn't whether interest rates are going to rise but how soon they'll rise and how fast they'll go once they start," according to a report in its latest Southwest Economy publication.
Using a macroeconomic model to guess where the Federal Reserve will push the funds rate using weak versus strong economic recovery scenarios, the Dallas Fed found the results varied widely and uncertainty ruled.
"The answers depend strongly on how much slack is thought to remain in the economy and on how quickly it is eliminated in coming quarters," it said.
An example of economic slack would be over capacity in manufacturing or high unemployment and its existence allows the economy to grow faster without sparking inflation.
Coming out of the 2001 recession, the American economy was thought to have built up a lot of slack.
But since strong March and April jobs reports, as well as rising prices, markets are betting the Fed will start raising the rates from a 1958-low of 1 percent next month.
Fed fund futures contracts actually indicate rates at 4 percent by the end of 2005. But the Dallas Fed's work argued for caution.
"The fact that short-term interest rates must eventually rise does not necessarily mean that they should increase immediately or sharply."
In fact, it found that small differences in assumptions made about the output gap and the non-inflationary rate of unemployment - tools to help gauge the speed at which economic slack is tightened - make a big difference.
"A 1 percentage point difference in output growth relative to potential output growth produces a 3.5 percentage point difference in the funds rate over two years," it said.
All of which meant it was very hard to guess the course of future Fed policy.
"Even if Fed policymakers followed a mechanical rule - which they emphatically do not - small differences in economic forecasts and assumptions might produce strong differences of opinion about current policy and about how policy ought to evolve in the future," the article noted.