Markets on edge about US Federal Reserve meeting

World financial markets remain on edge, nervous that the US Federal Reserve will today signal a move towards higher interest rates. Wall Street share prices recovered some of their early losses late yesterday, but a signal from the Fed today that higher interest rates are on the way could lead to further losses in international markets.

Fears of a shift in US central bank policy have risen in the past week, but the outcome of today's policy-making open market committee meeting is likely to be finely-balanced.

A Fed tilt towards tighter monetary policy could foreshadow a long-awaited turn towards higher interest rates in the rest of the world.

It could raise concerns about whether the US can continue to act as the engine of demand for the global economy.

Few expect the Fed to increase its key target federal funds rate from its current 4.75 per cent, where it has remained since the central bank cut rates last year in response to international financial turmoil.

The uncertainty is whether the Fed will, for the first time, signal concern about rising inflationary pressures, by announcing a change in its policy `bias' from neutral to one in favour of tightening.

Yesterday, European stocks followed up Friday's sharp US drop with further declines. In early afternoon, the Dow Jones Industrial Average was down by almost 120 points, though it recovered ground later. Bond prices recovered somewhat from their sharp sell-off on Friday, with the 30-year Treasury at 5.906 per cent.

At each Federal Open Market Committee meeting, policy-makers, led by Fed chairman Alan Greenspan, agree to a directive that indicates whether they think the next move in rates will be up or down.

The `bias' reflects the balance of opinion on the 12-voting member committee about the future direction of monetary policy.

At the end of last year, the members decided to make public immediately any changes in the policy stance, if they think it is important for the markets. Since the last rate cut in November, the bias has been neutral, meaning that policy-makers were leaning neither towards raising nor cutting rates.

But since then, the economy has continued to grow at an annual pace of more than 4.5 per cent, and unemployment has declined to a 30-year low.

Last Friday, after months without evidence of rising inflation, April's consumer price index figures showed the largest leap in nine years. Prices rose by 2.2 per cent in the year to April, and that rate is likely to rise further in the next year.

"The Fed will shift today to a tightening bias in response to diminishing world financial instability and the increasing risk of broader US inflationary pressures down the road," said Mr Allen Sinai, chief economist at Primark Decision Economics, a consultancy in New York.

But other Fed-watchers disagreed with this analysis. "Greenspan's approach is: Don't do anything unless you have to," said Mr Jim Paulsen, chief economist at Wells Capital Management in Minneapolis. "Apart from the consumer price index, there really is little else to worry them."

Other evidence suggests the consumer price index was an isolated case of inflationary pressure.