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More effort needed

Martin Hutchinson 

Fed: The faces a signalling problem when it wants to shift monetary policy. With stock markets strong, the economy recovering and commodity prices buoyant, the US target overnight interest rate should be much higher than the current zero to 0.25 per cent. However the has gunned monetary policy for so long that it can’t increase rates quickly without inciting panic. It could try harder than it is, though.

Economists often think of an interest rate about 2 percentage points higher than the inflation rate as neither stimulative nor restrictive in terms of monetary policy. In an economy still fragile as it emerges from deep recession — but with stock markets and commodity prices rising rapidly — short-term interest rates should probably exceed inflation but only narrowly, indicating a mildly stimulative stance. With US consumer price inflation excluding food and energy running at 1.4 per cent over the last 12 months, that might suggest a Fed funds target rate in the 2-3 per cent range.

The Fed thus has a problem. If it moves rapidly towards that kind of interest rate target, the rate jumps required would be large, and would probably spook the market, causing renewed economic downturn. Equally, though, the US central bank needs to bear in mind the experience of 2003-06, when it raised interest rates up only in quarter-point increments, moving so slowly that reaching an appropriate level took more than two years, allowing asset price inflation to soar and stoking the bubble that has now deflated so spectacularly.

In that context, the Fed’s statement on Wednesday erred on the side of laxity. With the monetary accelerator having been flat to the floor for a year, moving back to a reasonable policy inevitably involves a substantial shift. Beginning that shift, in order to get market players used to the idea, is a matter of urgency to head off potential inflationary pressures.

Telegraphing a coming quarter-point increase in rates — or even doing it — would have sent the right message without too much danger of meaningful damage to sentiment. But while the Fed nodded to improving conditions, it didn't even raise the possibility of interest rate increases. The risk in such kid-glove treatment is that any tougher stance comes too late to prevent markets once again getting ahead of themselves.

First Published: Fri, September 25 2009. 00:22 IST
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