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The Federal Reserve is set to raise its key overnight interbank rate by a surprise 0.25 per cent next Tuesday when the Federal Open Market Committee meets, a senior banker from a top global bank specialized in currency trading told us.

This will signal an end to the brief era of near zero interest rates as a policy response to the worst global financial crisis since the Great Depression. It will serve both as a check to inflation and bolster confidence in the US dollar while reminding investors that asset prices have become inflated.

Window jumping

The interbank rate rise will follow last month’s unexpected increase in the discount rate from 0.5 to 0.75 per cent. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans from their regional Federal Reserve Bank’s lending facility, the so-called discount window,

The interbank rate is the effective benchmark for all loans made in the US financial system. Any change in the latter has major implications for the US economy and by default the rest of the world.

By raising interest rates at this point in the cycle the Fed will be both proving its confidence in the tentative economy recovery that chairman Ben Bernanke has proclaimed, and underlining its commitment to preserving the value of the US dollar at a time of mounting deficits and bond issuance programs.

But there is much downside risk to this strategy. If the recovery is actually weaker than thought then the raising of interest rates could help push the economy into a double-dip recession.

Crash or correction?

There will also be an inevitable revaluation of financial markets to reflect the higher cost of money. Again there is a risk that if confidence is not as strong as generally held then financial markets will crash rather than undergo a healthy correction.

Recovery in economies and markets is seldom in a straight line, and the Fed will be only too aware of the dangers of fueling up an even bigger bubble in US equities and bond prices.

Reflationists will throw their arms up in horror at this action as imperiling a very fragile recovery. But it is a very fine judgment call, and a lot will depend on how much credibility the markets give the accompanying statements from the Fed about the likely speed of additional rate rises.

However, the Fed has to keep its street-cred and being a part of the gradual global tightening of interest rates – after a long period of loose monetary policy – should actually be better for the long-run health of the economy.

Disclosure: Author is long the US dollar

Source: Fed to Raise Overnight Rates by a Surprise 0.25%?