John M Berry: Bombs put pressure on cash cost

The Federal Reserve is well positioned to deal with whatever follows financially after last week's terrorist bombings in London.

With the US economy expanding and inflation under control, it may be that no supportive Fed action is needed to keep the economy on that sustainable non-inflationary track.

On the other hand, if growth were to falter, the Fed's boss, Alan Greenspan, may pause in his steady drive to increase its target for the overnight lending rate, which now stands at 3.25 per cent, up from 1 per cent a bit more than a year ago.

At the moment, another quarter-point increase at the Fed's next policy-making session on August 9 still looks overwhelmingly likely.

Should even stronger medicine be needed, the Fed may reverse course now that the overnight rate target is up off the floor and any threat of deflation has disappeared.

Financial markets continued to function last week without disruption. If this isn't followed by further bombings, either in London or elsewhere, there may well be little impact on the US economy.

In Britain, it could be a different story.

Consumer spending in the UK was already weakening and many analysts had been predicting the Bank of England would cut interest rates in coming months. As it happened, Thursday was the day for one of the bank's monthly policy announcements, and it made no change to its 4.75 per cent rate.

The bombings undoubtedly will damage consumer confidence, which had sagged after the home-price boom reversed. The attack may also hurt confidence in much of Europe where economic growth is weak, particularly in Germany and Italy.

"For the attacks to have lasting financial market consequences, they must affect behaviour sufficiently to generate a central bank response," economists at Goldman Sachs said. "At this point, the prospects of this seem low."

The economists said they expected the Fed to raise its overnight rate target by a quarter-percentage point next month. They already were expecting the Bank of England to ease at the August meeting of its Monetary Policy Committee.

"To the extent that the attacks affect confidence and spending, then the impact is to reinforce the pressures in the UK for a rate cut."

Just as the Fed did after the September 11 attacks on the US, the Bank of England issued a statement indicating it stands ready to supply additional liquidity to the banking system if needed - though it said on Thursday none was required.

Of course, the September 11 attacks on financial markets in the US were more significant because the physical damage in New York disrupted the markets, some of which were closed for days.

"Additional near-term terrorist activities in the UK or elsewhere would probably see the consequences being much bigger, along the lines of post 9/11, amid fears of a significant loss in business and consumer confidence," the Goldman Sachs economists said.

If growth weakens in the UK and elsewhere in Europe and it doesn't in the US, that will probably cause the value of the dollar to rise and the US trade deficit to widen.

By Friday, the British pound, whose value had already been falling relative to the dollar as the prospects for UK growth weakened, dropped below $1.75. Six months ago, US tourists were sometimes paying as much as $2 for a pound.

As for the Fed, it would take a significant shift in the economic outlook for officials to decide not to raise their rate again next month.

With a new round of incentives for some vehicle makers, retail sales may have picked up again last month after a weak showing in May, and Government tax receipts suggest incomes are growing strongly enough to support continued gains in spending.

For example, Neal Soss, chief economist at Credit Suisse First Boston in New York, is predicting a good second half, with 3.75 per cent GDP growth." And growth of "about 3.5 per cent" should follow in 2006.

That is very much in line with what many Fed officials expect to see for the remainder of this year and next. So long as US economic news is consistent with that sort of forecast, the officials are going to keep moving their rate target up.

Soss said he expected the overnight rate target to reach about 4 per cent by the end of the year, and he added, "If you think the economy is going to do well next year, as we do, then why would you stop?

"You might just go slower in the tightening process than you have. So rather specifically we think they'll get to 5 per cent Fed funds by the end of 2006."

- BLOOMBERG