Marketplace, June 23, 2004
Two events will affect -- hopefully not roil or rock, but certainly influence -- global markets by the middle of next week. The first is the transfer of authority in Iraq to the provisional government, scheduled for June 30th. The second is the decision by the Fed's Open Market Committee, also expected by June 30, to lift interest rates from their 40-year low. Although treated as separate stories in the news, the two are in fact closely related.
The reason is that markets hate uncertainty. Knowing that something big might happen but not knowing whether it will, or how big it will be, causes many investors to hold back until the coast clears. It also causes many businesses and consumers to delay expenditures until more is known. So uncertainty is itself a cost that reduces the market value of assets, and retards their growth.
If the transfer of power in Iraq goes smoothly -- if oil pipelines there and in Saudi Arabia get by relatively unscathed, if transportation and communication facilities throughout the Middle East and Europe are unharmed, if there are no major strikes against the United States -- then global markets will breath a large sigh of relief and the world economy can get on with its business much as before.
As to the Fed, well, it's likely to raise the overnight rate it charges member banks by at least a quarter point when it meets next week, meaning that short-term interest rates will rise by that much. Alan Greenspan has already signaled it, and markets have taken it into account. It will be the first rate increase since May of 2000, the first increase after a slump since 1994. The economy is on an upswing, and the Fed is determined to make a preemptive strike against inflation.
Now, if all goes relatively smoothly with the transfer of power in Iraq, and the extra uncertainty hanging over the global economy lifts, then the value of all assets will rise and continue to rise. Hence, more upward pressure on prices. Therefore, expect further rate increases from the Fed through the summer and fall, bringing short-term interest rates up to about 3.5 percent by the end of the year.
On the other hand, if the transfer of authority in Iraq goes badly, if instability in the Middle East continues or increases, then uncertainty will weigh down global markets. Yes, oil prices may rise. But investors, companies, and consumers will hold back enough to keep most other prices in check. Inflationary expectations will dim, and the Fed's Open Market Committee will be reluctant to raise interest rates any further.
Donald Rumsfeld and Alan Greenspan control entirely different parts of the government, but Rumsfeld's war in Iraq has a direct effect on Greenspan's war on inflation.
