US economy prepares for a rates rise as the era of cheap money comes to an end

Federal Reserve widely expected to raise rates as inflation becomes a concern again
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The Independent Online

If drawing the sting of interest rate increases is the central banker's supreme art, then its supreme practitioner is Alan Greenspan. Anyone in the financial community who has not been holidaying on the planet Mars is aware that the Federal Reserve will raise short-term US interest rates today for the first time in four years.

If drawing the sting of interest rate increases is the central banker's supreme art, then its supreme practitioner is Alan Greenspan. Anyone in the financial community who has not been holidaying on the planet Mars is aware that the Federal Reserve will raise short-term US interest rates today for the first time in four years.

The only marginal doubt about the early afternoon statement wrapping up the Federal Open Market Committee's two-day meeting is whether the increase will be the 0.25 per cent generally expected by the markets, or the 0.5 per cent predicted by those who still believe the Fed chairman likes to keep the odd trick up his sleeve.

But even the latter would be a modest jolt indeed, after 13 months during which the target Fed Funds rate has stayed at 1 per cent, the lowest since the late 1950s when Dwight Eisenhower was in the White House.

Nor does the medium-term future hold great terrors for the markets, which have already priced in an increase to 2.25 per cent by the end of 2004, and to 3.75 per cent 12 months later.

If they are correct, even that latter figure would be below what economists consider a "neutral" Fed Funds rate of 4 to 5 per cent, when the central bank is seeking neither to stimulate nor cool the economy.

Nonetheless (unless Mr Greenspan astounds the universe by doing nothing), today marks the end of one cycle, ushering in a new one of rising rates, more suitable for an economy which beyond any doubt is now well into a solid and broadening recovery.

By most measures, the Fed's relaxed monetary stance of the last four years has been a resounding success. More than a dozen successive rate cuts since the last increase on 16 May 2000 have shepherded the economy through daunting times: the shuddering end to the boom, the September 11 terrorist attacks, mild recession and, finally, last year's deflation scare.

In the event, the 2000/2001 recession was the shallowest of recent times and the unemployment rate has risen by less than in most previous downturns. Nor can the Fed be blamed for the country's massive external and internal deficits.

In 2004, the balance of risk is very different. Back in 2001, the greatest dangers were recession, replaced by the "jobless recovery" of 2002 and 2003, and deflation, trapping the economy in a downward spiral of falling prices, demand and output.

Today, the terrain is more familiar and more reassuring. Despite a downward revision of first-quarter GDP, the 12 months to March 2004 showed growth of more than 4 per cent, the best year-on-year performance in 20 years. After the loss of 2.6 million jobs during the first three years of the Bush presidency, 1 million were created between March and May alone. The main peril is no longer deflation, a spectre of the 1930s, but that more recent and better understood bugbear called inflation.

Depending on the measure, inflation is now running at between 2 and 3 per cent. Surging oil and energy prices are one reason, but the "core" rate of 1.6 per cent has caught the Fed by surprise ­ leading some economists to doubt whether the FOMC will indeed be able to deliver a soft landing, the "measured" tightening it spoke of after its last meeting.

No one will be watching more closely than the Bush White House, faced with a tough re-election battle this autumn. It is part of Bush family legend that Mr Greenspan's excessively tight monetary policy unneccessarily prolonged the 1990/91 recession, costing the father re-election in 1992. The last thing Bush the son wants is a repeat performance ­ and the chairman, recently reappointed by the President to a fourth and final term, is unlikely to rock the boat.

A dozen years on, the economy is in much better shape than then; but for all the fine figures, ordinary Americans are yet to be persuaded that they are reaping the benefits. And, indeed, this has been a corporate, not a people's, recovery. Productivity has soared, and with it business profits ­ but not wages nor, until recently, jobs.

Iraq is not the only reason why some 60 per cent of the populace believes the country is going in the wrong direction ­ a figure that historically says an incumbent president will not win a second term. The biggest applause on the campaign trail for John Kerry comes when Mr Bush's Democratic challenger points out that the share of ordinary workers' wages in the overall economy is the lowest in modern US history.

But, to use the classic central banking metaphor, has the Fed left the punch bowl on the table too long? Four years of ever cheaper money have kept consumer spending buoyant. But they have also produced record debt, fuelled in part by the long surge in house prices cheap money has brought. Like their British counterparts, US homeowners draw from the soaring value of their most important asset like a piggy bank.

The spectre of a house price collapse here may be less scary than in Britain, but it stalks America's economic landscape nonetheless. In contrast to the UK, most mortgages here are fixed-rate and higher rates may not immediately mean higher mortgage payments. But if house prices were to go into reverse, a key prop of demand would be removed.

All the more reason therefore for old father Fed to move slowly and deliberately, telegraphing its every move so as not to frighten the children. Back in 1994, the last time the central bank raised rates to curtail a perceived inflation threat, its unexpected aggressiveness positively terrified them. Super-rich Orange County in California plunged into default, and only a US-led bail-out package saved Mexico from a similar fate. Since then Mr Greenspan has vastly improved the Fed's intelligence about market expectations.

Barring a sudden and unforeseen spike in inflation, there will be no surprises this time around. Indeed, some Fed-watchers map the future thus: a 0.25 per cent rise today, followed by a 0.5 per cent increase in August; then nothing until the presidential election is over, and a 0.5 per cent increase in December.

Which leaves, of course, the deficits. Nothing the Fed does today will make much difference to either the US trade deficit or the federal government's deficit, both running at a little under 5 per cent of GDP.

Left untended, in the long term these imbalances are unsustainable, as Mr Greenspan has repeatedly warned. Ultimately, America's ability to cope with them depends on the willingness of the rest of the world (above all China, Japan, and the Middle East oil producers) to hold the dollar as a reserve currency. Higher interest rates will make the dollar a more attractive investment, and faster growth in the US than in the old industrial countries of the G7 also increases America's appeal for foreign capital looking for a home.