The Fed attempts to save the world

By Rod Oram

Between the lines

"Much of the financial strain has eased, foreign economies have firmed and economic activity in the United States has moved forward at a brisk pace."

So said the US Federal Reserve yesterday, giving the global economy a pat on the back for recovering from a brush with disaster.

Last year, one economy after another stumbled, leaving the world teetering on the edge of the abyss of deflation. Alarmed, the Fed cut US interest rates three times in three months to ensure its domestic economy sucked in imports to pull the rest of the world back from the brink.

With the rescue accomplished, the Fed signalled in May a switch in its focus. To prevent US inflation rekindling, it said its next change in interest would likely be a rise.

Forewarned, financial markets were relaxed about yesterday's increase in the Fed funds rate.

Trouble was they were too relaxed. They over-celebrated when the Fed said it was adjusting its outlook from a bias towards raising interest rates to a neutral stance.

This was taken to mean the Fed was so comfortable with economic conditions it was unlikely to raise its rates again soon. Euphoria spread far and wide. US markets rallied, pushing down interest rates. But that left monetary conditions easier - the opposite of what the Fed was trying to achieve. The reaction was even more ebullient abroad. Mexican stocks, for example, rose 3.3 per cent.

But what the Fed actually said was different. It said it picked a neutral stance because it could not make up its mind what the economic data meant. It talked of the "uncertain resolution of the balance of conflicting forces in the economy."

The confusion goes beyond opaque language, though, to an historic change in the way the Fed communicates with the markets. For the first 86 years of its life, a stoic Fed just did what a central bank had to do without talking about it first.

Then, last December, it said it would henceforth disclose whether its was thinking of making a major change in monetary conditions.

So now markets are far more interested in what the Fed says than what it does. This is a classic trap central bankers are prone to set themselves.

Only when they realise the uncertainty and confusion their chattering creates do they learn to shut up. Don Brash, our own central bank governor, is one of the chastened.

The Fed first exercised its new loquaciousness in May, saying it was biased towards raising interest rates. And, behold! It raised them yesterday.

But don't be suckered by the Fed's talk of a neutral stance. Interest rates in the US - and New Zealand - will edge higher this year.

But think of this not as a burden but as a fair price for saving the world.