New York Market: Fed moves slowly towards rate increase

THE Federal Reserve may decide on Tuesday to raise interest rates - but not immediately - because of last month's jump in consumer prices.

The central bank has not raised rates in more than two years, and most firms were forecasting before Friday that its policy would stay neutral.

"We're changing our call, given how strong the economy is," said Henry Willmore, an economist at Barclays Capital. Barclays is among the firms bracing for a shift in the Fed's stance, along with Morgan Stanley Dean Witter and Salomon Smith Barney.

The switch came after the government said that consumer prices had risen 0.7 per cent in April from March - the largest monthly gain in almost nine years. The release signalled an acceleration in inflation, which erodes the value of bonds. US Treasury bonds reacted by posting their biggest decline in almost three years.

Joe Carson, an economist at Deutsche Bank Securities in New York, thinks the economy may be strong enough to compel a rate increase as soon as Tuesday. He puts the chance of this at 49 per cent.

He is alone, however, in calling for an increase so soon. Most economists and investors think the Fed will start with a warning on Tuesday, and not actually announce an increase until much later in the year. William Gross, at Pacific Investment Management, said: "The Fed's on alert. I'm on alert, too. I've been expecting higher inflation."

Judging by Eurodollar futures, among the securities most sensitive to Fed rate policy, expectations are building for a rate rise in the months ahead. The implied yield on the September Eurodollar contract climbed 13 basis points to 5.24 per cent on Friday. That is almost a quarter point more than the current three-month borrowing rate of 5 per cent.

Stocks plunged, led by financial shares after the inflation report. The Dow Jones Industrial Average slumped 1.8 per cent to 10,913.32, its third- biggest drop this year. The S&P 500 declined 2.2 per cent and the Nasdaq by 2.1 per cent.

"The market is acting as if the trend of low inflation is ending, and we are beginning a period of inflation moving up,'' said Robert Streed, a money manager with Northern Trust.

Abby Joseph Cohen, the revered Goldman Sachs' investment strategist, does not agree. She told clients that despite Friday's plunge, she remains upbeat. "We don't believe we are on the cusp on an increase in global inflation."