Fed likely to continue with rate rises

RECORD oil prices and the underlying inflationary threat suggests the US Federal Reserve will continue to raise rates in the months ahead.

Rates are likely to hit 2% by the end of the year, Bloxham senior economist Alan McQuaid predicted yesterday.

Depending on the strength of US growth and the level of inflation, rates could hit 3.5% to 4% over the next 18 months, he said.

In Europe, however, the rate climate is less pressurised with growth in the eurozone slower than many had hoped for.

Niall Dunne, of Ulster Bank Financial Markets, said the US has called it wrong on interest rates. Since early summer, 10-year bond yields have fallen from 4.87% to 3.96% yesterday.

Falling long bond yields suggest a benign interest rate climate. Both Mr McQuaid and Mr Dunne say a definite move upwards in US interest rates has clearly begun; it is just a question of by how much they will rise.

Oil prices are up at 20-year highs; New York went to $48.46 yesterday.

Mr Dunne said that will put pressure on inflation, which the Fed will have to react to.

Higher oil prices are also inflationary and that, combined with still robust economic growth, suggests the Fed is committed to keeping rates on a steady upward curve, despite three consecutive 0.25% rises.

ECB president Jean-Claude Trichet, addressing bankers in Dublin on Thursday, said that “higher oil prices have had a visible impact on euro area inflation.” It implied higher rates on the way but not just yet.

US rates have gone from 1% to 1.75% in three months, while the ECB will mark time and keep its historic low interest rate regime intact until the first quarter of 2005, said Mr McQuaid. What the Fed will do next, and the ECB for that matter, depends on the rate of economic pick-up and the level of inflation.

Historically, the 10-year average inflation figure has been 2.5% against the headline figure of 2.8%.

Alan McQuaid believes inflation is a factor, but not major in the overall context of the current US economic cycle.

In his view oil is obviously crucial and he expects the price to say above e40 per barrel for the rest of the year. Over the next 18 months the trend will be downwards.

But the most optimistic figure for the price per barrel is looking closer to €35 over the next few years than the figure of €24 that had been around until Iraq and concerns over oil supplies spooked the markets, he said.

On the interest-rate front Mr McQuaid says there will be no move from the ECB until the first quarter of 2005, given the state of the eurozone economy.

At worst, interest rates will be 3% by the end of 2005, he said.

He says the Fed will continue to raise rates suggesting one more hike by year end to bring rates up to the 2% ECB base rate level.

By the end of next year, rates could be anywhere between 3.5% and 4%, but that will depend on how strong US growth becomes and whether oil prices get better or worse. He expects the price to stay above €40 per barrel for the rest of the year, but he predicted a downward trend over the next 18 months.