Lower interest rates may take some time to come

Hopes for a cut in interest rates by the Federal Reserve receded further last week. And to add insult to injury to bond investors, China and Japan appear to be resuming their monetary tightening campaigns.

While most of the world's economists were focussed on developments in the United States, the world's largest economy, developments on monetary policy on the other side of the world also shared the limelight last week.

One development was the announcement by the People's Bank of China (PBC) on Friday that the required reserve ratio for financial institutions engaged in the deposit business in the country would increase by 0.5 percentage points from January 15. This was the fourth such move by the PBC in a year and will bring the reserve requirement to 9.5 percent.

Then there were various news reports in Japan speculating that the Bank of Japan might be preparing to raise interest rates this month. As a result, the yield on the 10-year JGB rose 3.5 basis points last week to 1.71 percent after touching a 1-1/2-month peak of 1.715 percent on Thursday.

Finally, we have developments in the United States suggesting that the Federal Reserve is likely to keep the target federal funds rate unchanged for an extended period.

A healthy labour market will be a major factor. While much of the US economic data released during the week had been mixed -- indeed, even on employment, the ADP National Employment Report had indicated that the private sector lost 40,000 jobs in December -- the employment report from the Bureau of Labor Statistics on Friday indicated that nonfarm employment increased by 167,000 in December while average hourly earnings rose 0.5 percent. It was a surprisingly strong report for an economy that is supposed to be well into a slowdown.

Other employment-related data released during the week -- specifically those on claims for initial jobless benefits, planned job cuts surveyed by Challenger, Gray & Christmas Inc and the employment readings from the Institute for Supply Management surveys -- tend, on the whole, to support the picture of a healthy labour market.

The employment report on Friday caused expectations for a rate cut in the first quarter of the year to be lowered.

There were also signs from the Federal Reserve itself last week that reinforced the view that a first quarter rate cut is unlikely.

On Wednesday, the minutes of the Federal Open Market Committee (FOMC) meeting in December were released. The minutes showed that the committee thought that "the economy seemed likely to expand at a moderate pace" and that "inflation risks remained of greatest concern and that additional policy firming was possible".

On Friday, in a speech to the Connecticut Business and Industry Association, Boston Fed President Cathy Minehan said that "2007 will bring continued moderate growth, with GDP at or a bit below potential". On the other hand, inflation "has been and remains a challenge", with core inflation over the 12-month period to November remaining "close to its third-quarter high, suggesting inflation may be slow to taper off".

On the same day, in a speech to the Labor and Employment Relations Association, Chicago Fed President Michael Moskow said that "recent changes in population growth and labor force participation imply that we need to change our benchmark for employment growth to something more like 100,000 per month". This means that the recent rate of job growth can be viewed as "quite solid".

Then, after noting the difficulty in boosting worker productivity recently, he said: "The slower growth of available workers and the rate at which trends in educational attainment and labor market experience add to those workers' productivity both...suggest that the contribution of labor to potential output growth may have declined by a bit more than half a percentage point since the late 1990s."

In a nutshell, what Minehan and Moskow are saying is that the US economy probably cannot grow much faster than it recently has been without pushing up inflation, which is already near a high. Hence the FOMC's continuing concern with inflation risks. This in turn means that the Federal Reserve is unlikely to entertain suggestions of a rate cut anytime soon.

So with the world's most important central bank likely to remain on the sidelines for a while more as far as explicit action is concerned, the fate of global interest rates over the next few months lies mainly in the hands of other central banks. And the latest indications are that these central banks are taking interest rates up.