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S. Balakrishnan

ALL the rate suspense has gone in the last few meetings of the US Federal Reserve's Federal Open Markets Committee (FOMC), which sets the Fed Funds and discount rates.

The message has been clear and unmistakeable - the FOMC will keep raising rates (at a measured pace though) till they reach a normal ("neutral") level from the historic bottom of 1 per cent which prevailed in the second half of 2003 and much of 2004.

America's GDP is growing at about 3.5 per cent per year. The second half of the nineties saw exceptional performance but the statistical phenomenon of "mean reversion" has seen growth slip back to the secular rate.

For a mature economy, the figure is impressive. Japan and Europe are still struggling - the former from the overhang of bad loans in banks and low capex and the latter from rigidities in business practices and labour markets. The US continues to be the destination of choice for First World investments.

Mr Alan Greenspan, the Chairman of the US Federal Reserve, knows all this. He is sanguine about the economy. He will keep monetary policy and interest rates accommodative to support expansion at around the current level. His fear, all along, has not been inflation but a slowdown. In fact, till mid-2003, Mr Greenspan fretted about deflation taking hold in the US economy as it did in Japan. Rising productivity reduced costs and competition reduced prices - the perfect recipe for deflation.

The Fed seems to have staved off falling prices - it didn't have to do much, thanks to surging oil and commodities. Satisfyingly, for Mr Greenspan, these have not led to higher core inflation, i.e., excluding food and energy.

The Fed's biggest worries are probably the fiscal and trade imbalances. They have the potential to destabilise the dollar (which has already happened to a large extent) and bond yields, if foreign investors in Treasuries (they account for almost half the ownership) exit US assets.

For the first time, about a month back, Mr Greenspan explicitly referred to this possibility in a speech, provoking a sell off in bonds.

In sum, another 25 basis points increase in the current FOMC meeting can be taken as a given. The post-meeting statement will not deviate in tone from the past, but could refer to incipient inflation pressures arising from the dollar's fall. Import prices, ex-oil, were up 0.7 per cent in November, on top of 2.7 per cent last month.

Rates are on course to 2.5 per cent, but, after that, the Fed will decide on its stance for the rest of 2005 and beyond depending on the pace of growth and behaviour of inflation.

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