The Hindu Business Line : Fed rate could go up 50 bps

ALL eyes are riveted on the US Federal Reserve as its Federal Open Markets Committee (FOMC) meets on Tuesday and Wednesday to decide on interest rates. With economic data on the strong side and a significant rise in inflation, the market's concern is when and how much the Fed will move. `Fed watching' is the name of the game and, in the process of divining its actions, fortunes can be made or lost.

So, what is the prognosis this time around? There is almost a universal agreement that the Fed will raise rates 25 bps. Hence, the focus is more on what the Fed will say rather than what it will do.

Unusually, ahead of perhaps an inflexion point in interest rates, Alan Greenspan and his FOMC colleagues have been quite clear on three things: (a) the current extraordinarily low rates cannot continue indefinitely (b) inflation is ticking up but is unlikely to rise much and (c) the Fed will abandon its gradualist policy of `measured' increases, if contrary to its expectations, inflation accelerates.

One would have thought that these contain enough hints of what the post-meeting statement will say. The speeches of Fed officials in recent weeks, in fact, foreshadow the customary FOMC announcement.

There is, however, a much broader issue, going beyond the current meeting and that has to do with the so-called `neutral' (neither stimulative nor restrictive) rate of interest. Most economists think it is high time the Fed pushed interest rates up to the neutral rate as early as possible. Estimates of the neutral rate vary from 2.5% to over 4%. But there is little doubt that it is well above the present Fed Funds rate of 1%.

The questions that then remain are: What is the neutral rate in the Fed view and will that be reached in baby steps or quicker? Also, will the tightening be spaced out or compressed in time?

Greenspan has not been dubbed the greatest central banker of all time for nothing. He is likely to be on spot in his forecast of non-accelerating inflation. And his estimate of the neutral rate in current economic conditions will probably be closer to 2.5% than 4%. All of which implies a measured pace of rate rises will be the policy.

Yet there is more than a marginal probability of the Fed moving 50 bps in this meeting itself, if only as evidence of its keenness to eventually move to a neutral rate. It will also reassure markets of its seriousness about fighting core inflation, if that does rise above 2%.

In less than the next 24 hours, all will be known.

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