US rate rise predicted to save dollar

THE FEDERAL Reserve is set to raise US interest rates this week.

Economists are convinced the key US discount rate will have to be raised for the first time in five years in order to underpin the weak dollar and calm the jittery bond markets.

Stephen King, deputy chief economist at James Capel, said an increase could come as early as tomorrow. Suggesting that the market had turned more bearish about the outlook for US rates, Mr King said the Fed could raise the benchmark Fed Funds rate half a point to 4.25 per cent. This is likely to be accompanied by a half-point rise in the discount rate to 3.5 per cent.

'This kind of rate increase is just one of many that we'll see throughout the year, which could take us to 6 per cent by year-end,' he said.

Fears of a rise in US rates pushed share prices down on Wall Street on Friday, with the Dow Jones Industrial Average closing 26 points lower at 3,669.5. US bond prices also fell sharply, dragging gilts down with them.

The chances of a rate risewill be increased if the dollar remains volatile. Last week the world's major central banks led a concerted effort to prop up the US currency by buying dollars in the market.

Amid concern over the dollar, the pound ended last week relatively unscathed by the Conservatives' drubbing in the local elections. It could be boosted if the Bank of England's quarterly inflation report on Tuesday warns that underlying inflation is still not heading down towards the Government's target of 1 to 2.5 per cent by Parliament's next recess, as that would imply little scope for another interest rate cut.

Market strategists say the short-term outlook for the UK stock market is dictated by the US bond markets.

Mark Tinker, UK strategist at James Capel, said: 'It will be a dull summer, but at some point it is a better than even chance that the market's fundamentals will reassert themselves.'

Sushil Wadhwani, a strategist and director at Goldman Sachs, agrees the UK stock market is in for a quiet summer, but thinks it might be spurred higher if economic growth slows down in the United States.