Cost of borrowing might be raised too high by Fed, observers fear

Cost of borrowing might be raised too high by Fed, observers fear
By Dave Shellock
Published: June 27 2006 03:00 | Last updated: June 27 2006 03:00
Copyright The Financial Times Limited 2006


Caution remained the watchword in global markets yesterday as the countdown to Thursday's US interest rate decision continued.

With a quarter-point rise in the Fed funds rate to5.25 per cent now fully factored in, the key will be whether the US central bank offers hints about whether further increases are on the cards.

There are fears among analysts that the Fed might end up raising borrowing costs too much and choke off economic growth in its efforts to fight inflation.

Ed Yardeni, chief investment strategist at Oak Associates, said he believed the US central bank had exaggerated the inflation problem facing the US.

"Over the past few weeks, the Fed has been transformed from a cautious central bank pursuing a 'measured' approach to maintain a balance between inflation and growth to one that is willing to be more reckless to achieve price stability even at the risk of causing a recession," Mr Yardeni said.

He feels US rates will peak at 5.5 per cent in August and that there is a growing chance the Fed will ease next year.

"My relatively optimistic outlook is based on my view that the inflation data over the next three months or so will be surprisingly subdued. It's hard for me to get worked up about the situation when productivity is growing so rapidly and unit labour costs are so flat."

A poll conducted by UBS/Gallup showed that investor optimism has fallen to a new low for the year in June.

According to the survey, six out of 10 investors fear that the Fed will raise interest rates too much.

Wall Street edged cautiously higher as optimism about a wave of bid and merger activity outweighed rate concerns.

At the close, the Dow Jones Industrial Average was up 0.5 per cent, the S&P 500 was 0.5 per cent higher and the Nasdaq Composite index gained 0.6 per cent.

European interest rate policy came back under the spotlight after a European Central Bank official suggested the pace of monetary tightening in the eurozone might be accelerated.

Yves Mersch, a member of the ECB's governing council, said the central bank had not ruled out raising rates by 50 basis points. Most economists see a quarter-point tightening from the current 2.75 per cent at the end of August.

His remarks helped the euro rally off a two-month low against the dollar and climb towards a fresh all-time against the yen. European government bond prices continued to fall, pushing the yield on two-year paper to the highest level for nearly four years.

An early advance for European shares, which largely came on the back of hopes of consolidation in the steel sector, quickly ran out of steam. The FTSE Eurofirst 300 index settled 0.3 per cent lower.

Asian stocks edged higher as steel issues attracted buyers. In Tokyo, the Nikkei 225 Average inched up 0.2 per cent to a three-week high, Taipei added 1.1 per cent but Mumbai fell 3.8 per cent.

Turkish shares dropped to their lowest levels for eight months following an aggressive rise in local interest rates on Sunday. The lira rebounded after the central bank intervened in the market to sell dollars.

Commodities trading was mixed ahead of the Fed's policy meeting. Gold drifted down a shade but copper and nickel advanced after Phelps Dodge of the US announced plans to buy two Canadian miners for a total of about $40bn. Oil prices edged ahead despite news that output in Iraq had risen to the highest level since the fall of Saddam Hussein.