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Thursday March 30, 2006 - 15:01:28 GMT

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US interest rates ahve peaked

The key issue for the next few months is that Federal Reserve decisions on interest rates will be much more dependent on US economic data, especially as policy is now slightly restrictive. This factor will contribute to increased market volatility as sentiment will swing in response to individual releases.

There will be further unease over inflation trends, especially if there is a further rise in capacity use. There is also still the risk that high energy prices will be passed through into wider cost pressures, particularly if oil prices rose again. Overall, however, inflationary pressure should remain under control.

Growth in the economy should remain firm in the short term, but the interest rate sensitive areas are already showing evidence of a slowdown and this trend is liable to continue. Given the high debt burden, the US consumer sector is not in a good position to absorb rising borrowing costs and the economy could react rapidly to any further increase in yields with a very sharp slowdown.

Overall, the Fed funds rate is likely to have peaked at 4.75%, although a further increase to 5.0% in May should not be ruled out. Any increase to levels above 5.0% would be likely to weaken the US economy sharply.

Inflation remains in focus

The Federal Reserve has continued to increase US short-term interest rates, with another 0.25% increase to 4.75% at the latest FOMC decision on March 28th pushing rates to the highest level since 2001.

The central bank will remained concerned over inflation in the short term, primarily due to the fact that high energy prices and capacity constraints are causing some upward pressure on costs and prices.

The latest consumer price data recorded an increase a headline increase in prices of 0.1% in February. There was also a core increase of 0.1% with the annual rate holding steady at 2.1%. The volatility injected by high energy prices was illustrated by the producer price data for the same month. There was a 1.4% drop for the headline rate as food and energy prices reversed January gains while there was a 0.3% increase in core prices. The latest industrial capacity use data recorded an increase to 81.2% in February, which is above the 81.0% average recorded over the past 25 years, but still some distance way from peak levels of 85.0%.

The Fed will aim to keep core inflation in a 1-2% target range which suggests that the rate is near the top of the comfort zone.

Focus on earnings

Hourly earnings have been increasing steadily over the past few months and there has also been some evidence of higher unit labour costs as productivity growth has dipped. A tighter labour market would also increase the risk of rising wage pressures. In the latest Beige Book, however, the Fed reported that there was no evidence of upward pressure on labour costs. It is also significant that labour-market participation rates have fallen over the past year and there should be scope for higher employment levels during 2006 which would ease the threat of higher wage pressures.

Dual mandate for Fed

The Federal Reserve has a dual mandate of maintaining price stability and the highest possible level of employment. The central bank will, therefore, want to see a controlled slowdown in the economy rather than stop growth in its tracks. The Fed will be placed in a very difficult situation if underlying inflation edges stronger at the same time as growth starts to slow significantly.

The labour market has remained strong over the past few months with the unemployment arte below the 5.0% level while there has been firm and consistent growth in employment with jobless claims at the lowest level for five years.

Retail spending has also been distorted by weather patterns, with a jump in sales for January due to warm weather reversed in February as the headline data recorded a drop of 1.3%. Consumer confidence rose in February, but the household debt levels mean that the sentiment could deteriorate rapidly if incomes come under pressure or debt-servicing costs continue to rise.

In this context, the housing sector will remain very important for the US economy and interest rates over the next few months. The most recent evidence has been mixed, with abnormal weather patterns causing further distortions in headline rates. Existing home sales, for example, strengthened by over 5.0% in February, but sales of new homes fell by over 10% in the same month. Both sets of data recorded a further increase in inventories of un-sold homes and this excess will tend to weaken the sector over the next few months.

US bond yields have risen during March with 10-year yields rising to 4.8%, the highest level since the third quarter of 2004. Higher long-term interest rates will tend to weaken the housing sector through the action of higher mortgage rates as well as posing a more general threat to consumer spending levels.

Uncertainty will increase

Over the past 18 months, the Fed has been close to guiding policy on automatic by sanctioning 0.25% rate increases at every meeting.

Although difficult to estimate, a neutral level for monetary policy is likely to be when short-term interest rates are within a 3.5-5.5% range and, even if this estimate is slightly too low, the Fed funds rate is now at a neutral or possibly slightly restrictive level. Monetary policy also acts with a lag and the full impact of the tightening already sanctioned will not be seen until the second half of 2006.

Wider measures of monetary policy do not suggest that policy is restrictive at this stage, but do suggest that neutrality has been reached. The key issue is whether the Fed will need to sanction a more aggressively restrictive policy to keep inflation under control. Given the debt levels within the economy, the most likely outcome is that the Fed will not need to pursue a very aggressive policy. With such a low savings rate, there will be a high risk that the economy will suddenly slow sharply in response to higher interest rates.

What is certain is that the Fed will need to be much more sensitive to forthcoming economic data and it will not be possible to leave policy on automatic over the next few months.

Changes at the Fed

The March meeting was the first chaired by Ben Bernanke and there were also two new Fed governors. It will take some time for Bernanke and the new committee to establish their authority and style at the Fed. A particularly important focus will be whether there is strong support for a formal inflation target. Adoption of a target could be seen as providing an important policy anchor and would have important medium-term implications, although the short-term impact should be limited.

In the past, Bernanke has stated unease over the potential deflation threat and it is likely that rates will be cut quickly if there is evidence of deflationary pressure in the economy.


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