Washington provides the prelude to a year of rising interest rates

The coming period will be a test not just of the markets' nerve but also of the depth of support for central bank independence

Alan Greenspan, the chairman of the Federal Reserve Board in Washington, gives his Humphrey-Hawkins testimony to the US Senate Banking Committee tomorrow and Thursday. For people who are not up to speed on the finer points of US monetary procedure, all you need to know is that he gives this testimony twice a year and it is regarded as the most important guide to the future stance of US monetary policy for the next six months.

The thing that the markets will be looking for this time will be an indication of whether the Fed will increase interest rates in the face of a tightening labour market and very highly valued, maybe overvalued, shares. The Fed chairman does not make interest rate decisions by himself, but he is primus inter pares on the Fed's Open Market Committee, which does make the decision, and so his judgement will carry great weight. Short-term interest rates in the US have not changed for more than a year, and with the next FOMC meeting on 25 March, the immediate question for the financial markets is whether rates will go up then.

There are three forces suggesting that they might. First, Dr Greenspan warned back on 5 December about the "irrational exuberance" of Wall Street, and since then share prices have gone on rising. The Fed might feel the need to lean against this rise in case it gets seriously out of hand and a subsequent collapse threatens the stability of the whole financial system.

Second, monetary growth, something that central banks always worry about, has been nudging upwards again, as the graph shows. And third, there is some pressure from pay settlements in the US which suggest that pay rises might start to feed through into inflation later this year.

The professional Fed-watchers seem pretty evenly balanced about the likelihood of a rise in March, but they are generally agreed that if the Fed does not move next month, it is likely to tighten policy later in the year, perhaps in May. This will be a year of rising US interest rates.

It will also be the year of rising rates elsewhere in the world. UK rates will go up for reasons which are pretty clear: strong economic demand, some indications of asset price inflation, particularly in house prices, and a tightening labour market. Less obviously, it may also eventually see rising interest rates in the other main economies, in particular in Germany, where the good export performance will be further reinforced by the recent fall of the mark.

Domestic demand remains stagnant and unemployment has risen sharply in recent months, but the view of the Bundesbank is that this shows the need for structural reforms in taxation and the labour market, rather than further cuts in interest rates. Meanwhile the fall of the mark is starting to push up raw material and energy prices, something which will eventually start to worry the Bundesbank. In any case, money policy in Germany is quite loose at the moment: money supply is rising at the top of the target range.

Germany is not going to increase rates for some time, but it is at least conceivable that by the back end of this year rates there will be climbing too. If they go up in Germany they will rise in the rest of continental Europe. Finally, expect Japanese interest rates to start rising by the end of the year. At last there is an economic recovery, though a weak one by previous standards. The yen has become very much weaker in the past two years and that trend seems likely to continue a while yet.

Put all this together and what do you have? From the perspective of the financial markets there is the fact that they will, at some stage in the next year to 18 months, have to push up the hill of rising interest rates. The hill may not turn out to be very steep, but a hill it will be.

But there is another and completely different perspective: the view of the rest of us. Over the past five years there has been a gradual movement towards giving central banks greater independence in setting monetary policy and giving governments less independence in setting fiscal policy. Within the European Union this switch is explicit in the Maastricht process, which requires the banks to be made independent, and requires governments to trim their deficits to meet the Maastricht criteria. If monetary union happens, monetary policy will be entirely independent of political control.

Elsewhere the move has been more patchy. Here in the UK the Bank of England has been given some greater degree of influence and may be given more after the election. In the US there has been no explicit constitutional change to correspond with Maastricht, but the perceived success of Dr Greenspan at the Fed has given him enormous authority, while there has been continuing pressure to reduce the fiscal autonomy of the President and Congress, by measures such as the balanced budget amendment. In Japan the central bank has been formally given a greater degree of independence, though it is not clear how much this means in practice.

But these past five years of constitutional movement have been a period of falling interest rates. From a practical political point of view it is much easier to applaud the wisdom of a central bank that uses its independence to deliver cheaper money, than it is to cheer when it wants to put rates up.

So the coming period of rising interest rates will be a test not just of the nerve of financial markets, but also a test of the depth of political support for the concept of central bank independence. If the financial markets react badly to rising rates, then the pressure on political support for independence becomes all the greater.

So this arcane practice where the Fed chairman spends a couple of days being questioned by the US Senate has two levels of significance. It will be interesting, even for people who do not follow each twist and turn of US interest rate policy, to catch a feeling for the concerns of the Fed chief at this stage of the cycle. As the year unfolds we can then judge the level of comfort or concern of the Fed. But it is interesting also as an overture to the great debate which we will hear over the next three or four years about the proper location of monetary policy in the political process.

Higher interest rates are going to be unpopular. Should that unpopularity be loaded on to national central banks, an international central bank (such as will happen in Europe if EMU proceeds), or should it remain, in part at least, as a burden to be placed on elected politicians?

PROMOTED VIDEO
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
Richard Norris in GQ
mediaGQ features photo shoot with man who underwent full face transplant
News
Gardai wait for the naked man, who had gone for a skinny dip in Belfast Lough
newsTwo skinny dippers threatened with inclusion on sex offenders’ register as naturists criminalised
News
Your picture is everything in the shallow world of online dating
i100
News
The Swiss Re tower or 'Gherkin' was at one time the UK’s most expensive office when German bank IVG and private equity firm Evans Randall bought it
news
Life and Style
Attractive women on the Internet: not a myth
techOkCupid boasts about Facebook-style experiments on users
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Graduate / Trainee Recruitment Consultant - IT

£25000 per annum + OTE £40,000: SThree: Orgtel are seeking Graduate Trainee Re...

HR Business Partner - Banking Finance - Brentwood - £45K

£45000 per annum + Benefits: Ashdown Group: ** HR Business Partner - Senior H...

PA / Team Secretary - Wimbledon

£28000 - £32000 per annum + Benefits: Ashdown Group: PA / Team Secretary - Mat...

HR Business Partner (Maternity Cover 12 Months)

£30000 - £34000 Per Annum 25 days holiday, Private healthcare: Clearwater Peop...

Day In a Page

The children were playing in the street with toy guns. The air strikes were tragically real

The air strikes were tragically real

The children were playing in the street with toy guns
Boozy, ignorant, intolerant, but very polite – The British, as others see us

Britain as others see us

Boozy, ignorant, intolerant, but very polite
Countries that don’t survey their tigers risk losing them altogether

Countries that don’t survey their tigers risk losing them

Jonathon Porritt sounds the alarm
How did our legends really begin?

How did our legends really begin?

Applying the theory of evolution to the world's many mythologies
Watch out: Lambrusco is back on the menu

Lambrusco is back on the menu

Naff Seventies corner-shop staple is this year's Aperol Spritz
A new Russian revolution: Cracks start to appear in Putin’s Kremlin power bloc

A new Russian revolution

Cracks start to appear in Putin’s Kremlin power bloc
Eugene de Kock: Apartheid’s sadistic killer that his country cannot forgive

Apartheid’s sadistic killer that his country cannot forgive

The debate rages in South Africa over whether Eugene de Kock should ever be released from jail
Standing my ground: If sitting is bad for your health, what happens when you stay on your feet for a whole month?

Standing my ground

If sitting is bad for your health, what happens when you stay on your feet for a whole month?
Commonwealth Games 2014: Dai Greene prays for chance to rebuild after injury agony

Greene prays for chance to rebuild after injury agony

Welsh hurdler was World, European and Commonwealth champion, but then the injuries crept in
Israel-Gaza conflict: Secret report helps Israelis to hide facts

Patrick Cockburn: Secret report helps Israel to hide facts

The slickness of Israel's spokesmen is rooted in directions set down by pollster Frank Luntz
The man who dared to go on holiday

The man who dared to go on holiday

New York's mayor has taken a vacation - in a nation that has still to enforce paid leave, it caused quite a stir, reports Rupert Cornwell
Best comedians: How the professionals go about their funny business, from Sarah Millican to Marcus Brigstocke

Best comedians: How the professionals go about their funny business

For all those wanting to know how stand-ups keep standing, here are some of the best moments
The Guest List 2014: Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks

The Guest List 2014

Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks
Jokes on Hollywood: 'With comedy film audiences shrinking, it’s time to move on'

Jokes on Hollywood

With comedy film audiences shrinking, it’s time to move on