The Hindu Business Line : Fed to keep to baby steps in rate hikes

"... policy accommodation can be removed at a pace that is likely to be measured". That's what the Federal Open Market Committee (FOMC), the interest rate-setting body of the US Federal Reserve, said in its statement at the last meeting in December 2004.

Markets have taken the use of the word "measured" to mean that the Fed will not increase rates more than 25 basis points at each meeting.

The FOMC has seen no evidence of significant inflationary pressures in the US economy, particularly if food and energy are excluded from the price indices.

This allowed the Fed Funds rate to move up in baby steps from an ultra-low of 1 per cent to the current 2.25 per cent.

There are two questions to which markets would dearly love to know the answer as the FOMC gets into session on February 1 and makes its interest rate announcement along with the traditional accompanying statement the next day.

First, going forward, does the Fed think inflation is a worry? The minutes of the last meeting did reveal that some FOMC members were concerned about the compatibility of low interest rates with stable inflation.

Secondly, what do they see as the growth trajectory of the economy?

Their stance on these issues will decide the course of monetary policy and interest rates in the coming months.

The data thus far do not support the case for aggressive tightening. CPI, ex-food and energy, has not exceeded 0.2 per cent m/m in the recent past.

The personal consumption expenditure index (again without food and energy), believed to be Mr Alan Greenspan's favourite inflation gauge, has stayed well below 2 per cent, thought to be the threshold above which inflation alarm bells start ringing at the Fed.

On the growth front, the fourth quarter GDP growth was reported at 3.1 per cent (though a statistical error could lead to an upward revision) - neither hot nor cold, just about average and unlikely to prompt the Fed to change its gradualist approach.

What, then, is the upshot?

There seems to be nothing on the horizon to get the FOMC to abandon its present policy line of a measured pace of rate increases.

Of greater interest, in fact, should be the question of how the Fed would react if core inflation remains below 2 per cent. At some point, it would have had enough of raising rates.

Seen from this perspective, it is likely that the flattening of the US yield curve does not have much farther to go.

Just as back-end Treasuries seems overbought, the front-end looks oversold.

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