Fed expected to raise interest rates: Modest increase likely as Americans look for support from Group of Seven over dollar's continued decline

THE FEDERAL Reserve looks likely to tighten US interest rates when it meets tomorrow and Wednesday in an effort to keep the lid on inflationary pressures and support the sagging dollar.

But any rise is expected to be modest and insufficient to stabilise the US currency in the absence of concerted intervention by central banks.

Despite US wishes the dollar's decline is accordingly set to top the agenda at this weekend's meeting in Naples of the Group of Seven - the US, Canada, Germany, Japan, Britain, France and Italy. Brokers predict continuing turmoil on financial markets unless the dollar is stabilised.

But the Fed is reluctant to go further in defending the dollar, which has fallen to a postwar low against the yen - it closed last week at 98.65 yen and DM1.5965 - without the co-operation of Germany and Japan. It would also prefer to see both countries ease the pressure on the US currency by cutting their rates.

While there is agreement on the need for a stronger dollar, both the Japanese and the Germans are reluctant to cut rates further and are worried about whether market intervention is a feasible response.

Ryutaro Hashimoto, Japan's trade minister, said at the weekend that the G7 would have difficulty in co-ordinating action on interest rates. The last bout of central bank intervention on 24 June also bought only temporary relief.

The issue may also well become tangled in the ongoing row over Japan's burgeoning trade surplus, which the Americans blame in part for the dollar's weakness. The US wants Japan to deregulate and to cut income taxes in an effort to boost spending and shrink the surplus. But Tomiichi Murayama, the new Japanese prime minister, is not seen as politically strong enough to take drastic steps.

'If fiscal measures and substantial trade breakthroughs are needed to help stem the dollar's fall, we are in trouble,' said James Vestal, economist at Barclays de Zoete Wedd in Japan.

The Germans - who hold a Bundesbank meeting on Thursday - are even less likely to cut rates, fearing to encourage inflation.

At tomorrow's meeting the Fed's Open Market Committee is likely to opt to push up its Fed Funds target rate from 4.25 to 4.5 per cent. There is also speculation it may raise the discount rate by 0.5 points to 4 per cent.

Analysts believe the Fed, which started tightening credit policy in February fearing the economy was growing too fast, has further scope to raise interest rates based on domestic inflationary indications.

Although there has been some slowdown since February, some indicators, such as housing starts, and employment, indicate the economy may still be growing faster than the Fed believes is sustainable without inflation.

But a rate rise ahead of the G7 meeting would also conveniently signal to the US's partners that it was serious about stemming the dollar's slide.