Not all investors see a big Fed ease

By Ros Krasny

NEW YORK (Reuters) - While financial markets widely expect that the Federal Reserve will start a vigorous interest rate-cutting program in 2007, some big money managers believe the economy could be strong enough next year to even prompt a rate hike.

Major fixed-income investors at the Reuters Investment Outlook Summit in New York this week said that economic growth would not slow enough to warrant aggressive easing, and that the Fed would maintain its focus on tamping down inflation.

"To me, there's been a bias about being a bit more up-front in inflation" by the Fed, said Margaret Patel, portfolio manager at Pioneer Investments.

For now, though, fixed-income markets line up more behind the views of PIMCO's Bill Gross, manager of the world's largest bond fund, who expects pressure on the economy from the slumping housing market to force the Fed to ease.

Gross told the summit that the Fed would ease by as much as 100 basis points in 2007 from the current fed funds rate of 5.25 percent.

Rate cuts early in 2007 seemed inevitable after the Institute for Supply Management's November factory survey on December 1 dipped below the critical 50 threshold that separates contraction from growth. But fortunes reversed a week later when stronger-than-expected payrolls growth for the month rekindled wage inflation fears.

On Wednesday, rate futures projected an end-2007 funds rate of about 4.65 percent, or about 60 basis points of easing.

The 2007 assessments came as the Fed's policy-making committee earlier this week held rates steady for their fourth straight meeting.

Still, markets and Fed watchers have been roiled by choppy data that has left the true state of the U.S. economy an open question. The latest report, Wednesday's November retail sales, hinted at solid fourth-quarter growth.

Beyond Gross, commentators at the Reuters Summit were doubtful that the Fed is on the way to a cut.

"The best guess is the Fed will do nothing" in 2007, said Bob Morris, chief investment officer at Lord Abbett & Co.

Morris said the Fed will guard its monetary policy ammunition carefully. "Even if the economy is a little weaker than forecast, the Fed always worries about its tool kit. When the fed funds rate was down to 1 percent (in 2003-04) they had no bullets left," he said.

Patel, meanwhile, said wage pressures related to signs of tightness in parts of the labor market could keep inflation above the Fed's presumed comfort zone and forestall any move to lower rates.

Moreover, she said the economy would quickly bounce back from a soft patch, and "after mid-year, it's at least 50-50 we could see the Fed start tightening."

Patel forecast growth in gross domestic product at a trend-like 3.0 percent to 3.5 percent for 2007, compared with PIMCO's tepid, housing-driven 1 percent to 2 percent for the year.  Continued...