Don't fear the Fed

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The Independent Online
All eyes will be on the US Federal Reserve open market committee today. It is widely expected to sanction a further rise in American interest rates, which in turn is widely expected to provoke a further shake-out in bond prices. At least that is what the brokers have been threatening, though often when the pundits agree, their markets do something different.

There are two ways of discussing the gradual tightening of US interest rates now taking place. One is to talk tactics, and attack or praise the Fed for the way it is handling the situation. After the first 1 4 per cent increase of rates in February and subsequent collapse of bond prices, there was widespread criticism of the Fed. It was argued by many in the market that it should have made a much sharper move, for the small size of the rise merely indicated this would be the first of many, rather than a once-and-for-all jump of, say, 1 per cent. The reply to this was that surely the Fed was wiser to signal intent and then gauge market reaction before moving again.

This sort of discussion is necessary and important for the market professionals; the tactics of the Fed do matter. But they matter only on a six-month or perhaps one-year view for it is a discussion about the fine-tuning of monetary policy, not about fundamentals. What ultimately matters much more is that the Fed should not make a serious policy error - for example, by failing to tighten policy as the US recovery matures. Fortunately, there is no evidence of such a failure. It has also prepared the ground for the tightening with extraordinary care, so that no one should have been surprised when this took place.

For the non-professionals - people who want to understand what is happening but are not interested in the daily or even weekly movements of US bond prices - there is another way of discussing the rate tightening. This is to look at the shape of the US economy and the changing structure of financial markets. If one does that, and then deduces what level of short and long-term interest rates might be appropriate, one is able to take a much longer view of bond market problems and potential.

RECOVERY SECURE

The thing to grasp about the US recovery is that it has become more 'normal'. In the early stages it seemed particularly halting. It did not seem to be creating employment, so people talked about the 'jobless recovery'.

There was no immediate bounce from the bottom, and so for some time people questioned whether the economy was growing at all. And then there was a stutter in the summer of 1992, which put paid to George Bush's chances of being re-elected.

But all that is history. Employment is rising by nearly 2 per cent a year. There was a little under 3 per cent GDP growth last year and there will probably be a little over 3 per cent this. And all sectors of the economy - capital goods, the all-important car industry, construction, housing, exports and so on - are now expanding. The recovery is broadly based and secure.

It is fair, then, to assume it will behave in much the same way it has before: at some stage, capacity shortages will start to show and inflation will rise. In fact, though rises in consumer prices have been muted, there are already signs of inflation at earlier stages of the production chain.

Industrial commodity prices are rising - the National Association of Purchasing Management price index is at the highest level for four years - and the leading inflation index calculated by the Bank Credit Analyst has moved through 100, suggesting the era of disinflation has ended.

LIMITED SQUEEZE

None of this should be taken to suggest that inflation will suddenly accelerate. But it is probable it will start to creep up, and will try to do so for the next two or three years. The Fed will have no option but to lean against this tendency by pushing up short-term interest rates.

How far will it need to go? That depends on how 'normal' is 'normal'. If the economic cycle is looking more and more normal, there are still unusual features in the financial cycle. These will limit the extent to which interest rates need to rise to combat inflation.

The most important of these unusual features is the degree of interest-rate sensitivity of US financial markets. Both consumer and corporate debt is still high by historic standards, though much of the excess has been worked off, helped by the very low rates. More important, the financial markets themselves are extremely sensitive to rising rates, as we have seen in recent weeks, so that any rise at all is going to dent the price of financial assets and hence damage confidence. Last, the general inflation psychology of the 1980s seems to have been broken.

So to achieve the same amount of disinflationary impact, the Fed will not need the same level of monetary squeeze. Because the US markets are frightened by the prospect of rising interest rates, the Fed does not need to increase them by as much as it otherwise would. But rates will still rise. The prudent must expect a peak for short-term rates of at least 5 per cent by the end of next year.

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