The end of cheap money era in the United States

If it were the central bank of any other country, no one would bother much about its raising inter-bank rate by one quarter percent. But the Federal Reserve happens to be the Central Bank of world's number one economy and any movement in its interest rates sends ripples throughout the financial markets of the world and often forces central banks of other countries to review their monetary policies. A movement in the benchmark rate of the Fed not only affects inflation, labour market , currency market and the economic growth in the US but also in the EU and the developing countries. This year, it may also have an impact on the results of the November presidential elections in the United States. So in this context it is relevant to ask : Why Mr. Greenspan has chosen this moment to raise the inter-bank rate ?

Money has actually been very cheap in the US for a considerable period of time. The recent US bank rate (1 per cent) has been the lowest since 1958 and this modest increase ( 0.25 per cent ) is the first such increase in four years. This easy-money policy has not been accidental. After the collapse of American stock market in 2000, when there were genuine fears of the spread of deflation (when prices fall or remain the same for a long time) in most industrialised countries, the Fed started slashing interest rates. Actually before yesterday's increase, the Fed had resorted to thirteen interest rate cuts to bring it down from 6.5 per cent to 1 per cent. The US rate has been the lowest among the major industrialised countries of the world except Japan ( 0.10 per cent), which for a number years has enjoyed ( or suffered ) near zero interest rate because of falling prices (deflation). While the current inter-bank rate in the UK is 4.50 per cent and 5.25 per cent in Australia, in the euro area it stands at 2 per cent.

The principal reason for Mr. Greenspan's recent announcement of a "measured increase" in the interest rate is the fear of inflation, which has been creeping up slowly. Actually Mr. Greenspan has himself been warning since last year that the benchmark rate of 1 per cent could not be sustained any longer without fuelling inflation. According to many analysts, inflation is still under control but if corrective measures are not taken now, things may get out of hand. ( No one wants to go back to the double-digit rates of the seventies.) In the US, while annual inflation up to May, last year was 2.1 per cent, this year the rate has shot up to 3.1 per cent for the same period. There is also a clear tendency that it will go up even further in the next few months, if measures are not taken now . There is a similar inflationary trend in the EU, where annual inflation to May has risen to 2.5 per cent. ( In Spain , it now stands at 3.5 per cent) . The European Central Bank had forecasted a maximum of 2 per cent for the euro area. True, in both cases, the main reason for this rise has been higher oil prices. In China, inflation may exceed 5 per cent at the end of the year. Even Japan, which for years was in a deflationary situation, consumer prices have stopped falling. There are clear indications that this year, the consumer-price inflation will be positive. Now the question is : Is this small increase in American interest rate enough to head off inflationary pressures?

Here, Mr. Greenspan is performing a delicate balancing act. He realises that such a low interest rate is not enough to stave off inflation. Yet he realises that he cannot raise it too high and too fast , which would create havoc to many companies and families, who have acquired properties and assets worth billions of dollars during this long period of cheap money without worrying too much about the level of their indebtedness. He does not want to provoke an uncontrolled slow-down of the economy either, which has grown at an average annual rate of 5.6 per cent for the past nine months or so. No one is sure of the depth and possible duration of this recovery. True, productivity growth has been spectacular and hundreds of thousands of new jobs have been created . But Mr. Greenspan , as the head of the Federal Reserve also wants to keep inflation under control , hence this policy of measured increases in the interest rate over a period of between 12 and 18 months.

According to some economists the US economy still has considerable "slack". The more slack there is in an economy, the better the chances are for keeping the inflationary pressures under control. Even though the employment situation is better than before , still there are many millions of unemployed or underemployed workers in the labour market and by all accounts considerable spare factory capacity is also available in the industrial sector. The unemployment rate now stands at 5.6 per cent and the industrial capacity utilisation is 76.9 per cent. So Mr. Greenspan hopes that by keeping a close watch on the pace of economic growth , the unemployment situation , the wage pressure and by raising the interest rates gradually to a maximum of say, 4 per cent by the end of 2005, he will be able to maintain control over the economic recovery and the inflation.

However, at present there are several other economic factors at play and it is difficult to foresee how they will affect Mr. Greenspan's gradualist policy . The latest published figures indicate that America's balance of trade and current account deficits are not getting any better .On the contrary, the current account deficit has reached a record 5.1 per cent of GDP in the first quarter of 2004. No doubt, this situation is partially due to high oil prices -- the US continues to be the world's number one importer of crude oil. This situation together with its huge fiscal deficit ( caused by Bush's reckless tax-cut policy) is weakening the dollar , thereby increasing the prices of imported goods . According to some analysts, the US government may be forced to borrow $ 5 trillion or more over the next 10 years to finance these deficits which will inevitably force the interest rates to rise because the simple rule in economics is : If the demand for a commodity ( in this case money) goes up, the price ( in this case interest ) should go up as well.

Unfortunately, higher interest rates in the US have a negative impact on debt-ridden developing countries as well because debt- financing and debt-repayments become more expensive.

Although some analysts expected the European Central Bank (ECB) president, Mr. Trichet to follow the Fed policy, on the 1st of July, he completely discarded any such idea for the moment. Of course, he kept the door open for a rate increase at the end of the year. The ECB is forced to pursue this policy because of uncertain economic recovery in the euro area. In fact, in Germany, which happens to have the largest economy in the euro area, retail sales declined 1.5 per cent in May. This fragile situation was further underscored by an unprecedented agreement between Siemens and IG Metal, Germany's most powerful union, under which the workweek was extended from 35 hours to 40 hours without an increase in the wages. Meanwhile, higher interest rate ( the speculators are convinced that this modest increase is only the first in a series of increases to come in the near future) in the US should strengthen dollar against the euro, which in turn should help the euro area's export efforts. This, in turn, should help this area's economic growth, which is lower than that of the United States. However, one should add a word of caution here. For reasons explained above, dollar's rally against the euro (fed by expected interest rate increases) may be short-lived.

The Fed is scheduled to meet twice (on August 10th and September 21st ) before the November presidential elections. An increase in the rate of interest will most probably hurt the current incumbent of the White House. Now the big question is : Following his gradualist policy, will Mr. Greenspan dare raise interest rates again before the election? If Mr. Greenspan's past record at the Fed is anything to go by ( after the end of the first Gulf War, he refused to manipulate interest rates to favour Bush senior's chances of victory), my guess is that Mr. Greenspan will not hesitate to take difficult decisions if he feels that they are necessary for a steady economic recovery in the United States.