US signals shift towards higher rates

THE US signalled a shift towards tightening interest rates yesterday, responding to the first signs of a revival in inflation.

Although it did not move rates, the Federal Open Market Committee said it had moved from being neutral about the future of interest rates towards an expectation that the next move would be upwards.

"The Committee was concerned about the potential for a build-up of inflationary imbalances that could undermine the favourable performance of the economy and therefore adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy," it said in a statement.

"Trend increases in costs and core prices have generally remained quite subdued. But domestic financial markets have recovered and foreign economic prospects have improved since the easing of monetary policy last fall," the committee said. "The Committee recognises the need to be alert to developments over coming months that might indicate that financial conditions may no longer be consistent with containing inflation."

The announcement shook financial markets, even though the shift in bias has been widely anticipated for the past few months. The Fed has indicated that it is rethinking its decision to cut rates last year and has reassessed the continuing strong growth in the economy. The Federal Funds rate and the discount rate remained unchanged at 4.75 per cent and 4.5 per cent respectively.

The Fed Funds rate fell by three-quarters of a percentage point between September and November 1998. It has been at 4.75 per cent since 17 November.

Speculation peaked when consumer price inflation figures on Friday showed a sudden surge in inflation, with a 0.7 per cent jump in April sparked principally by rising energy prices.

But America presents a mixed picture to monetary policy makers. On the one hand, consumer demand is resilient, unemployment is very low and labour markets are tight. On the other hand, there is little indication that this is feeding through into a wage-price spiral, and there are some signs of weakness. Construction of new homes and apartments fell by 10.1 per cent in April, the Commerce Department reported yesterday, the biggest fall in five years.

The stock market fell heavily on Friday and moderately again on Monday as equity analysts digested the impact of a change in policy. Bond markets have been reflecting a shift in policy since last December, and the yield on the benchmark 30-year Treasury bond has already risen by nearly a full percentage point to near 6 per cent. The mortgage rate for 30-year loans has risen to 7.10 per cent, so rising rates are already cutting into economic activity.

The monetary policy stance received the backing of the Organisation for Economic Co-operation and Development yesterday. "There is no need to be pre-emptive," OECD chief economist Ignazio Visco said after the release of the OECD's "Economic Outlook". "The US can afford the luxury of awaiting an endogenous slowdown."

Mr Visco said growth would slow to 3.6 per cent this year, a sharp upward revision from its last estimate of 1.5 per cent. "With inflation still low and the economy expected to slow, there are no immediate pressures to change the present stance of monetary policies," the OECD said.

The Dow Jones Industrial Average, which had been up 60 points, fell by about 50 points after the rates announcement.