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Wednesday, Nov 10, 2004

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Is 2.5 pc Greenspan's neutral rate?

S. Balakrishnan

THE Presidential elections are over and Mr George W. Bush keeps his job.

The US has taken a decisive turn to the (extreme?) right on foreign policy and social issues.

What about the economy? A Republican President presides over a spiralling fiscal deficit. His party has historically been a strong advocate of prudence in the management of public finances. Of course, the trailblazer in this regard was a Republican predecessor, Mr Ronald Reagan, whose Presidency saw the Budget spinning out of control. Ironically, it was in Bill Clinton's Democratic Administration that the US Government started running surpluses, enabling Democrats to claim to be the champions of fiscal conservatism.

The other big headache for the US is the trade deficit, which continues to deteriorate with alarming speed. The doomsayers predict that the dollar will fall sharply, but even that may not necessarily solve the problem, given the emergence of numerous low-cost producers of goods and services the world over, eager to export to the US. They are happy to feed the insatiable appetite of US consumers.

Economic growth continues to be decent - third quarter GDP rose 3.7 per cent, a little less than expected but nothing to scoff at. After all, Europe and Japan are struggling to avoid recession.

Last week's non-farm payroll also brought good news - 3,37,000 new jobs were created.

It is against this backdrop that Mr Alan Greenspan and his colleagues on the Federal Open Markets Committee (FOMC) meet on November 9-10 to decide on interest rates. The last three meetings each saw a rise of 25 basis points taking the Fed funds rate from 1 per cent to 1.75 per cent now.

This time, the FOMC's decision looks a no-brainer The election is out of the way — increasing rates on election eve would have been construed negatively by the Bush Administration and holding off would have attracted allegations of partisanship.

The economy is performing well given the circumstances and considering the relentless march of crude prices to well over $50 at one point. The threat of deflation is all but gone; the CPI, ex-food and energy, actually rose 0.3 per cent last month.

Thus, the Fed's stance of progressing to a neutral interest rate regime from an ultra soft one will continue and one could surely expect another increase of 25 basis points at the current Fed meeting.

In fact, with further falls in crude prices extremely likely, giving growth an extra boost in the coming quarters, the Fed's rate moves may pause only after reaching 2.5 per cent in early 2005. The implications for US bonds are clear. Yields are poised to rise quite a bit with 10-year Treasuries pushing to the range of 5 per cent.

Short maturities will be hit badly and 5 years should be seeing 4 per cent levels soon.

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