The Fed makes a stitch in time

The only question that matters in the financial markets this morning is whether the Federal Reserve changed the world at 4.15 pm (London time) last Friday when it announced a quarter-point rise in American interest rates. Is this the start of a global monetary tightening that will spell doom for stocks and bonds? Or is it a non-event?

The answer depends partly on what Alan Greenspan, Chairman of the Federal Reserve, is really up to. In Mr Greenspan we have a truly successful central banker - a man who has conspicuously failed to become hung up on a misleading single indicator, and a man whose previous judgement on monetary policy has proved both pragmatic and peerless. One of the reasons for his excellent track record is that he has always succeeded in moving monetary policy well in advance of trouble, and in very small doses at any one time. He no doubt believes that he is doing the same again.

Mr Greenspan has explained to Congress several times in the past year that the exceptionally low level of American interest rates (3 per cent in nominal terms, zero in real terms) could be permitted only for as long as the US banking system was repairing its balance sheets, and consumers were regaining their confidence. Once these remedial operations had been completed, there was never any question that Mr Greenspan would start the lengthy process of nudging short- term interest rates higher.

The only surprise was the timing of the first move. With inflation pressures still very subdued, or even subsiding further, most observers felt that the Fed would follow its past practice and leave monetary policy on hold for a while longer. In the past, central banks have tended to tighten monetary policy around 12 months after the trough in inflation, by which time they could make out a watertight case to politicians that unpleasant medicine was needed. This time, the Fed has taken a calculated political risk by acting well in advance of the usual timetable.

Admittedly, the American economy is now three years into a healthy upswing, and has all but eliminated the 'output gap' between actual and trend GDP. Capacity utilisation in the manufacturing sector (around 83 per cent) is also close to the level that has triggered inflation in the past. But the unemployment rate remains quite high by US standards (6.7 per cent), and there is no sign whatever of inflationary pressures in the labour market.

What the Fed has done through this early tightening is put a dampener on expectations of a rise in inflation, which can be very painful to correct once they have been allowed to let rip. Further US policy tightening now seems likely in the rest of this year, though this will probably be much more gradual than the markets expect. Short-term US rates should still be below 4 per cent at the year-end.

In the long term, if this slow- but-steady strategy works, it can be nothing but beneficial for the world economy, and therefore for both stocks and bonds. But in the immediate future, the markets will undoubtedly worry that the prime fuel for recent bullish sentiment - low interest rates - is beginning to wane.

There is no question that the main reason for 20 per cent total returns last year in both equities and bonds was the sharp decline in short-term interest rates around the world. Taking a weighted average of the G7 economies, short rates fell from 5.7 per cent to 4 per cent during 1993, and all of this was unanticipated by the markets at the start of the year.

There will undoubtedly now be fears among some investors that the central banks could deliver unpleasant interest-rate surprises on average this year. In particular, the action of the Fed has made life much more difficult for the Bundesbank, since it will heighten the dilemma between exchange rate and domestic objectives, which is now being acutely felt in Frankfurt.

This is rather ironic, since it is precisely the same dilemma that the Bundesbank itself imposed on the rest of Europe for so long in the early 1990s. By increasing the market's awareness of this dilemma, Friday's move could well lead to further marked weakness for the mark - just as any twitch towards tighter policy by the Bundesbank used to have exaggerated effects on other recession- ridden European currencies within the ERM.

With the domestic German economy now threatening to dip back into recession, lower interest rates there are surely still inevitable, but they may now be accompanied by a sharp weakening in the mark against the dollar.

If the mark does weaken precipitously, the Bundesbank may take longer to deliver rate cuts than the markets expect. This could be dangerous for the long end of the bond market in Germany, since the market has already 'priced in' significant easing by the Bundesbank.

And if the German bond market performs poorly, the rest of Europe will probably suffer at least a temporary setback. 'Speculative' investors, notably the American hedge funds, have been exceptionally heavy purchasers of European bonds in recent months, and market sentiment could temporarily turn nasty if these investors lose patience.

UK ON THE HIT LIST

These same investors will also start to speculate about who will be the next to tighten monetary policy. Given the recent buoyancy of activity in this country, the UK will be high on the market's 'hit list', and the result could be a significant further rise in sterling against the mark. (Incidentally, although there will probably be calls for the Chancellor to follow the Fed in opting for a pre-emptive tightening of monetary policy, it should be remembered that the UK recovery started at least a year after that in the US, and from a much deeper recession. Kenneth Clarke will probably sit tight and do nothing at present.)

While the financial markets could therefore be volatile for a while, Friday's move in the end should be seen as good news. Because American inflation is more likely than before to be nipped in the bud, the GDP recovery there may be more sustainable - a recipe for good performance by both stocks and bonds.

Meanwhile, in Europe, domestic fundamentals will almost certainly dominate in the end. In the post-war period, economic cycles in the different countries have generally been closely correlated, so it has often appeared that the Fed has led the rest of the world towards easier or tighter money.

But this has not always been the case. From January 1983 to July 1984, American interest rates rose by 3.4 per cent, and bond yields were up by 2.6 per cent. Yet European domestic conditions did not favour higher interest rates, and in most parts of Europe rates fell in the face of this tightening by the Fed. Furthermore, European equity markets boomed, especially relative to the US.

Once early fears have subsided, the same may happen again this time - though Mr Greenspan's decision last week may certainly mean that lower European interest rates are consistent with weaker exchange rates against the dollar than would otherwise have been the case.