US rate rise fears prompt European market uncertainty

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The Independent Online
FINANCIAL markets are braced for a nervous week with fears mounting that the US Federal Reserve may announce another increase in short-term US interest rates.

Worries about higher US rates rattled world bond markets last week and prices slumped ahead of tomorrow's meeting of the Federal Open Market Committee.

Alan Greenspan, the Fed chairman, was unexpectedly called to a meeting with President Clinton on Friday, prompting speculation that the administration was putting pressure on the US central bank to hold back from increasing rates.

But if that was Mr Clinton's intention, some leading US analysts expect it to backfire. Bill Jordan, of Reid, Thumberg and Co in Fort Wayne, Connecticut, said: 'The effect of the meeting will make it very difficult for the Fed not to tighten because of its credibility; it almost forces the Fed's hand.'

As a politically independent institution, the Fed would be under pressure to distance itself from administration pressure. Economists predictably offered contradictory explanations for the meeting, with some suggesting another increase on Tuesday in the Fed Funds rate, from 3.25 per cent currently, was now 'inevitable'. If rates were not increased, 'the Fed will appear to have succumbed to political influence,' said Charles Lieberman, of Chemical Securities in New York. The Fed last raised the rate a quarter of a point on 4 February, the first increase in almost five years.

Upheaval in US markets spilled over into Europe and decoupled the markets from fundamentals like low inflation and prospects of further falls in short-term rates.

George Magnus, chief international economist at Warburg Securities, added: 'People are looking six or 12 months ahead to a period of economic growth, inflation fears and higher interest rates - that's what this correction is all about.'

Mr Magnus pointed out that the US and UK bond markets had fallen by about 12 per cent from the peaks established just before the Fed first raised rates in February. He predicted that, with a decline of this scale, a turnaround in bond markets was inevitable. Whether the Fed tightens monetary policy now, or waits until its next meeting in six weeks' time, is of less importance than the inevitability of higher US rates which is likely to unsettle financial markets for weeks, even months, to come.

Only a faster than expected drop in German rates, thought unlikely, could offset the bearish mood.

US economists say that Mr Greenspan is aiming to shift monetary policy from an 'accommodative' stance to one of neutrality. For the past two years, the Fed held the key funds rate at 3 per cent to revive the economy and allow the financially crippled banking system to recover. This has meant that real US rates, that is after inflation is excluded, have hovered around zero for a long period. In order to achieve a 'neutral' policy, observers say Mr Greenspan has to lift the Fed Funds rate 1.5 points above the inflation rate, currently 2.5 per cent. But growth is running at 3.5 to 4 per cent annually, well above the 2 to 2.5 per cent potential, leading economists to predict inflation to grow to around 3.5 per cent.

On this view, the Fed will have to lift the Fed Funds rate to around 5 per cent by year-end.