Coupled with the third-quarter productivity and unit labour cost data, it is clear that, barring the current account deficit, the American economy is enjoying virtually a benign combination of moderate to solid growth with little inflation pressures. Yes, the Federal Reserve has to catch up with the fact that there is little slack in the economy and that corporate profitability growth is in double digits as well. In other words, returns on relatively riskless assets have to rise, in acknowledgement of the robust returns earned on risky assets. It is a normalisation process and should not be seen as a counterweight to inflation. Based on this consideration alone, the Federal funds rate could peak closer to 5%. Financial markets are yet to price this in. But, they are not too far off. Federal funds rate futures contracts price in at nearly 4.75% by end-March 2006. Hence, one could say that financial markets have discounted most of the Federal Reserve rate increases. Barring a surge in economic growth in the US, the bulk of the rise in long-term Treasury yields is behind us.
Of course, such a growth surge would compel the Federal Reserve to keep pushing the Fed funds rate to 5.5%. That, again, should not worry financial markets, since that would be in line with the normalisation process described above, as long as the inflation rate is under control.
What should worry financial markets is the zeal with which central bankers are responding to perceived and real threats of inflation. Of late, the rhetoric of the Federal Reserve is worryingly similar to that of the European Central Bank (ECB). Noted economist and columnist Samuel Brittan, writing for Financial Times, calls for a less doctrinaire approach to monetary policy from the ECB. Far from that occurring, the Federal Reserve is trying to take a leaf out of the book of the ECB by talking of the need to remain vigilant against inflation.
The Bank of England is downplaying economic weakness signalled by the GDP figures in the UK. Instead, it is focusing on various economic surveys that point to more robust employment growth. HSBC economists argue that the survey data could be overstating economic strength, rather than GDP data overstating economic weakness.
Central bankers are over-responding to real and perceived threats of inflation
Their keenness to end the policy of easy rates is understandable, but to a degree
The need for tightening is varied; normalisation is more justified in the US
There are also itchy fingers in the Bank of Japan that want to end the policy of zero interest rates in that country. While there are definite signs of economic recovery, it is yet to be stress-tested. Whether the Japanese economic recovery has enough strength to outlast possible weakness in the US and in China is still a matter of conjecture. The misunderstand-ing between the ministry of finance of the government of Japan and the Bank of Japan on the issue of moving the interest rate up from zero became public this week.
Thus, in general, central bankers appear to be rather too keen to end the policy of easy rates that have led to significant gains in the prices of homes, bonds and stocks in the past three years in most countries. To a degree, this is understandable. In general, easy money leads to excess and wrong investments, eventually resulting in financial and/or economic crises. However, the degree of tightness required varies from country to country. Normalisation is justifiable in the United States than elsewhere. Further, it is one thing to identify a problem, but it is another thing to recognise that the solution might leave the economy worse off.
If central bankers end up raising rates, there is the real risk that the world economic growth would be sharply lower in 2006. After all, real winter in the western hemisphere is yet to begin. If there is a cold freeze from January to March, the price of heating oil could rise and consumer spending could clamp in the United States. Second, the threat of a bird flu pandemic still hovers in the air. Third, the threat of politically motivated supply disruptions to crude oil from West Asia has not disappeared. That could quickly reverse the recent decline in the price of crude oil. Given these outstanding risks, pro-active and pre-emptive higher rates might turn out to be the last straw that broke the back of global economic growth.
The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views