US rate hike reopens inflation debate

The Federal Open Market Committee of America’s Federal Reserve made a unanimous decision to raise interest rates by a quarter point to 3.25% last week. This is the ninth quarter-point hike in interest rates in America in the past year.

Short-term interest rates were set at 3% at the committee’s last meeting on May 3. Prior to this latest set of rate rises, American interest rates had remained on hold at 1% from June 2003 until June 2004, according to the Fed.

In spite of the rate hike, the Fed still maintains that its monetary policy is accommodative and is providing support to economic activity in the country, along with the underlying growth in productivity.

Although it admits energy prices remain high and pressures on inflation are elevated, the committee notes that economic expansion in America is firm and that conditions in the labour market are continuing to improve gradually.

According to the committee, chaired by Alan Greenspan, “with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal”.

The group also unanimously approved a quarter-point increase to the discount rate, which is now 4.25%. The committee is next scheduled to meet on August 9.

Charles Dumas, director and head of the world service at Lombard Street Research, recently noted that profit margins in America may become squeezed. A possible 3% growth in unit labour costs, on top of core inflation of 2%, is the main threat.

Above-average GDP growth in the third and fourth quarters of the year, combined with a positive output gap, could also push inflation near 3%, he says.

In addition to the profit squeeze, Dumas says that continued monetary policy tightening by the Fed into 2006 also poses a threat to stocks. “It is hard to see the Fed being able to stop this side of 5% unless stocks suffer a setback, holding back labour income via weaker options profits,” he adds.