Fearful markets eye the Fed

Financial markets are braced for a fresh wave of volatility this week as the US Federal Reserve prepares to push up interest rates to their highest level for five years.

Wall Street believes a quarter-point rate rise at the Fed's policy meeting on Thursday is inevitable, but investors will pore over the accompanying statement for signals about how much further borrowing costs could rise.

'If the Fed hikes a quarter of a percentage point and leaves the door open for more - data-dependent - rate hikes, market volatility is likely to stay sky high,' says David Brown, chief European economist at Bear Stearns.

Fed chairman Ben Bernanke, who has so far failed to convince the markets of his inflation-fighting credentials, must decide how much further he can increase rates without slamming the brakes on an economy that already shows signs of slowing. Inflation has been above expectations for three successive months, and some analysts have become nervous that high oil prices are feeding through to the rest of the economy.

'Bernanke's clearly having a rough rite of passage,' said Richard Iley, the senior economist at BNP Paribas in New York. 'He's taking over at a turning point, when mistakes can be made.'

Rates have already risen in 16 quarter-point steps, to 5 per cent, since June 2004, when the Fed, under Alan Greenspan, began returning borrowing costs to a more normal level, after slashing them to 1 per cent to stave off recession after the dotcom crash.

'Markets seem to want to test the Fed chairman, who may feel he is boxed in to delivering another rate move, even though many members of the committee may feel that they have already done enough,' Iley said. He expects rates to rise just once more after this week - to 5.5 per cent - and that an economic slowdown led by the weakening housing market will then force the Fed to cut rates by early next year.

Since mid-May, equities and commodity prices have slid amid simultaneous rate increases in Europe and the US and signals that Japan, too, is about to start tightening credit. The knock-on effects of this Wall Street wobble have reverberated throughout the world, as investors have retreated from high-risk assets in search of safer bets.

In Turkey, one of the worst-hit emerging markets, central bankers announced late on Friday that they would hold an emergency meeting today, after the lira slid towards an all-time low against the euro. The Turkish currency has lost more than 20 per cent of its value since mid-May, despite the central bank administering a confidence-boosting 1.75 percentage point rate rise and intervening in the foreign exchange markets in an attempt to stem the sell-off.

Ahmet Akarli, the executive director for Turkey and the Middle East at Goldman Sachs, said buoyant markets in recent years have masked policy mistakes in Istanbul, and that a slowdown in growth is inevitable despite the central bank's decisive response. 'They've done everything right, but it's too late,' he said.