Interest rate rises in US on the horizon

The improving trend in economic data, especially in the US, is fuelling expectations that interest rate increases are likely soon. Indeed, money markets are now betting on a rise in the closely watched Fed Funds rate as soon as the next meeting of the FOMC in May.

In recent speeches, Alan Greenspan has struck a decidedly cautious tone, emphasising the need for the corporate sector to begin to participate in the recovery process to ensure its sustainability. Judging by the latest round of profits reports, this is not yet happening.

However, as the recently released minutes of the January FOMC reveal, there was considerable debate on that occasion (which was in advance of much of the better economic newsflow) over whether the bias of policy should be returned to a neutral stance. This suggests that there is some unease about maintaining the widely watched Fed Funds rate at such a low level as 1.75%.

In Europe, the economic numbers have not turned up to the same extent as in the US. That has not stopped Wim Duisenberg striking an increasingly upbeat tone about the prospects, however.

And, although little has been said about the likely course on rates, the suggestion from the ECB that the growth performance on the continent could match the US's indicates that the Frankfurt-based monetary authority is unlikely to be far behind the Fed when the latter decides to change direction on rates. Significantly, the Swedish Riksbank has already taken the lead in this respect lifting its key repo rate by 25 basis points.

Surprisingly, given the resilience of the UK economy over the past 12 months, the policymakers at Threadneedle Street appear more relaxed about the immediate need for any tightening in the monetary stance.

Speeches by both Sir Edward George and his deputy, David Clementi suggest the MPC is willing to give the British consumer more time to moderate spending before taking any action. This may, in part, reflect that the adjustment to policy in 2001 was nowhere near as dramatic in the UK as in the US.

Real base rates may historically appear to be low but, given the anchor provided by the inflation target, they are probably not that far from what may be viewed as a neutral level. The same cannot be said of Fed Funds.

So, will the futures markets' aggressive expectations for rate increases this year prove more accurate than seemed plausible just a short while ago? If the economic data continues to firm, that is certainly the danger.

However, there is one factor that could still encourage caution from central banks and that is the general lack of pricing power. This is nowhere more clearly demonstrated than on the buoyant British high street.

Although non-food sales volumes are posting year-on-year gains of about 8%, prices are still falling. A recovery in the world economy without any meaningful pick up in inflation may seem difficult to believe but it could be a result of increasingly competitive product and labour markets. If so, the worst fears on interest rates may not be realised at the end of the day.

bull points

Improving trend in economic data.

MPC willing to hold off raising interest rates.

Ongoing resilience of UK economy.

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