Bernanke sticks to Greenspan formula

If it ain't broke, don't fix it. This appears to have been the theme driving Fed Chairman Ben Bernanke as he chaired his first Fed Open Market Committee meeting. The FOMC, as it is called, meets eight times a year to decide on the course of US interest rates.

At the second meeting for this year, Bernanke decided to go along with the by now tried and tested Greenspan formula of "measured" rate hikes. The result, the Fed hiked rates by 25 basis points (bps) to 4.75 per cent, the fifteenth consecutive hike since June 2004.

It was only a year ago that many market pundits were calling for the Fed stopping when rates hit 4 per cent. With inflation under control in spite of soaring energy prices and a potential housing bubble, there was really no need for the Fed to go any further. However, with rates now 75 bps higher and likely to still head north, many of those pundits are now calling for rates touching 5.25 per cent or even 5.50 per cent.

So what has changed? In reality, very little. The Fed believes that both core inflation and inflation expectations are still well contained.

While recent new home sales data showed a drop of 10.5 per cent, Bernanke feels that an expected decline in the housing market would not sufficiently hurt consumption to derail the solid economic growth. What however does keep the Fed worried and thus looking towards "some further policy firming" is the fact that resource utilisation, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

Moreover, with economic growth having rebounded solidly (as the Fed puts it), a rate hike was the only way to go. But the question that some are asking is "how real is the resource crunch?" Thus, is there a real danger that wage inflation that up until now has been kept in check thanks to productivity gains, could begin to perk up as the unemployment rate falls lower to 4.3 per cent.

Some argue that even if the unemployment rate in the US were to continue to fall, globalisation would continue to provide the necessary slack.

In today's world where both financial and human capital are free to move across the globe and given the US access to markets such as China and India, is there really reason to be concerned? The reality is that there are convincing arguments on both fronts and thus for the Fed and all its members, incoming economic data will continue to hold the key to when they will finally say "enough is enough".

The US is not the only region grappling with rising rates. Eurozone has a similar story to tell. The 5-year Euro swap rate has jumped from 3.10 per cent at the start of the year to above 3.7 per cent currently. As expectations of further rate hikes by the ECB have gained traction, yields have gone in just one direction. Interest rates in Japan too have continued to edge higher.

While the Bank of Japan ended its quantitative easing but left rates unchanged close to zero, the market is rooting that before long rates will be hiked. This has caused the yen 5-year swap rate to rise from 0.90 per cent at the start of the year to over 1.50 per cent currently. The Bank of England, which had actually cut rates, now appears to be applying breaks to expectations that further such cuts are in the offing.

I guess we all have to now get used to living in a world where rates are going up and will continue to do so for some time to come. As the cost of borrowing becomes expensive, we in turn will need to demand and achieve higher returns from the assets that our liabilities are funding.

Forecasting is at best a tool to guide our decision making, but is not a sure thing. In the end when the Fed will finally pause is a question to which even Chairman Bernanke may not have an answer!

- The writer is Regional Head of Sales, HSBC Global Markets, Middle East. The views expressed herein are his own and not necessarily those of his employer.