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
Tuesday 25 February 1997
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?
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