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?

Arts and Entertainment
Jamie Dornan stars as Christian Grey in the Fifty Shades of Grey movie
filmFirst look at Jamie Dornan in Fifty Shades of Grey trailor
Lars Ulrich of Metallica performs on the Pyramid Stage at Glastonbury 2014
Shinji Kagawa and Reece James celebrate after the latter scores in Manchester United's 7-0 victory over LA Galaxy
voicesGood for Lana Del Rey for helping kill that myth, writes Grace Dent
Farah returns to the track with something to prove
Commonwealth games
Life and Style
fashion Designs are part of feminist art project by a British student
Arts and Entertainment
The Tour de France peloton rides over a bridge on the Grinton Moor, Yorkshire, earlier this month
Very tasty: Vladimir Putin dining alone, perhaps sensibly
ebookA unique anthology of reporting and analysis of a crucial period of history
Arts and Entertainment
Top guns: Cole advised the makers of Second World War film Fury, starring Brad Pitt
filmLt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a uniform
Life and Style
Listen here: Apple EarPods offer an alternative
techAre custom, 3D printed earbuds the solution?
Snoop Dogg pictured at The Hollywood Reporter Nominees' Night in February, 2013
people... says Snoop Dogg
The University of California study monitored the reaction of 36 dogs
sciencePets' range of emotions revealed
Arts and Entertainment
A scene from Shakespeare in Love at the Noel Coward Theatre
theatreReview: Shakespeare in Love has moments of sheer stage poetry mixed with effervescent fun
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

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

iJobs Job Widget
iJobs Money & Business

Service Charge Accountant

£20,000 - £22,000 per annum: Recruitment Genius: This Property Management Grou...

IT Transition Manager - Stirling - Banking - £400

£400 - £420 per day: Orgtel: IT Transition Manager - Banking - Scotland - £400...

Test Lead - Financial Reporting - Banking - London

£350 - £400 per day: Orgtel: Test Lead, London, Banking, Financial Reporting, ...

Business Analyst, Retail Bank, £375-400p/d

£375 - £400 per day + competitive: Orgtel: My client, a leading bank, is curre...

Day In a Page

Screwing your way to the top? Good for Lana Del Rey for helping kill that myth

Screwing your way to the top?

Good for Lana Del Rey for helping kill that myth, says Grace Dent
Will the young Britons fighting in Syria be allowed to return home and resume their lives?

Will Britons fighting in Syria be able to resume their lives?

Tony Blair's Terrorism Act 2006 has made it an offence to take part in military action abroad with a "political, ideological, religious or racial motive"
Beyoncé poses as Rosie the Riveter, the wartime poster girl who became a feminist pin-up

Beyoncé poses as Rosie the Riveter

The wartime poster girl became the ultimate American symbol of female empowerment
The quest to find the perfect pair of earphones: Are custom, 3D printed earbuds the solution?

The quest to find the perfect pair of earphones

Earphones don't fit properly, offer mediocre audio quality and can even be painful. So the quest to design the perfect pair is music to Seth Stevenson's ears
US Army's shooting star: Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform

Meet the US Army's shooting star

Lt-Col Steven Cole is the man Hollywood calls when it wants to borrow a tank or check a military uniform
Climate change threatens to make the antarctic fur seal extinct

Take a good look while you can

How climate change could wipe out this seal
Should emergency hospital weddings be made easier for the terminally ill?

Farewell, my lovely

Should emergency hospital weddings be made easier?
Man Booker Prize 2014 longlist: Crowdfunded novel nominated for first time

Crowdfunded novel nominated for Booker Prize

Paul Kingsnorth's 'The Wake' is in contention for the prestigious award
Vladimir Putin employs a full-time food taster to ensure his meals aren't poisoned

Vladimir Putin employs a full-time food taster

John Walsh salutes those brave souls who have, throughout history, put their knives on the line
Tour de France effect brings Hollywood blockbusters to Yorkshire

Tour de France effect brings Hollywood blockbusters to Yorkshire

A $25m thriller starring Sam Worthington to be made in God's Own Country
Will The Minerva Project - the first 'elite' American university to be launched in a century - change the face of higher learning?

Will The Minerva Project change the face of higher learning?

The university has no lecture halls, no debating societies, no sports teams and no fraternities. Instead, the 33 students who have made the cut at Minerva, will travel the world and change the face of higher learning
The 10 best pedicure products

Feet treat: 10 best pedicure products

Bags packed and all prepped for holidays, but feet in a state? Get them flip-flop-ready with our pick of the items for a DIY treatment
Commonwealth Games 2014: Great Scots! Planes and pipers welcome in Glasgow's Games

Commonwealth Games 2014

Great Scots! Planes and pipers welcome in Glasgow's Games
Jack Pitt-Brooke: Manchester City and Patrick Vieira make the right stand on racism

Jack Pitt-Brooke

Manchester City and Patrick Vieira make the right stand on racism
How Terry Newton tragedy made iron men seek help to tackle their psychological demons

How Newton tragedy made iron men seek help to tackle their psychological demons

Over a hundred rugby league players have contacted clinic to deal with mental challenges of game