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INVESTORS NEED TO start preparing for a turbulent new era of rising prices, rising volatility and a much weaker US dollar as inflation and interest-rate concerns continue to dominate global financial markets.

Choosing investments without regard to prospects for inflation is like taking a holiday without checking the climate of the place you will be visiting.

Markets have completely priced in a rise of 25 basis points in interest rates when the Fed meets next week.

With the federal funds rate in the United States at 1 per cent,  an almost 46-year low, monetary policy is way too stimulative for an economy that is expected to grow by more than 4.4 per cent  in the first quarter.

Strong personal consumption, accounting for 66 per cent of GDP, fuelled by remortgaging activity, and personal debt in the US at record highs are the underlying drivers.

The inevitable by-product of this - inflation - however, is creeping back up and hence higher interest rates are inevitable as well as urgent, many argue.

So why is chairman Alan Greenspan obviously 'behind the curve' and reiterating his message to the market that a rate rise will only take place at a 'measured pace'? The key distinction is in the difference between nominal and real rates.

The answer is found in the housing market bubble and the fact that the US economy lives on cheap credit. For every dollar of GDP growth created, the economy is burdened with $2 of debt. Because of these legitimate fears, there is growing speculation that a more aggressive tightening will be sanctioned over the next few months.

At the moment, some market commentators and analysts predict that higher interest rates will help the dollar, and the dollar indeed was rising in the foreign exchange market as  Mr Greenspan  was trying to reassert the Fed's anti-inflation credentials. This makes public relations sense given the growing conviction that the Fed is dangerously behind the curve, keeping the accelerator too close to the floor.

Ironically, what might happen is that Fed policy will weaken the dollar even further.

Historically,  whenever the Fed starts raising interest rates, the dollar weakens on a trade-weighted basis, by about 2 per cent for every 100-basis-point  rise in the federal funds rate.

This relationship has applied in every tightening cycle in the past 25 years. So, if the Fed increases  by 250 basis points over the next 18 months, (and that is less than the median market forecast) the dollar should fall by at least 5 per cent on a trade-weighted basis.

On the one hand, the US consumer remains financially stretched, limiting dollar upside from higher interest rates. The corporate sector, on the other hand, remains in good shape.

This conflict between the need for higher yields to attract further bond inflows to finance the record twin deficits, and the increased sensitivity of consumption growth to higher interest rates is the crux of the issue.

The net result of these diverging trends most probably will be resolved in favour of negative 'real' interest rates and a much weaker dollar.

Negative real interest rates are inherently inflationary and create the potential for a vicious inflationary spiral. Over the past 20 years, all categories of debt in the US - government, business and consumer - have grown faster than the economy. But consumer debt has been the fastest growing segment.

When the economy is loaded with debt, it is essential that flow of money continues to grow. As interest rates rise, policymakers, to prevent debt from overwhelming consumers, will be pressed to keep economic growth strong to ensure that wages rise faster than rates. This will be a tremendous push towards further inflation.

In essence, inflation will beget further inflation as Mr Greenspan finds his hands tied by the existence of so much consumer debt.

For this reason alone, the Fed has to keep nominal interest rates low to prevent more problems in the housing and mortgage market. High consumer debt makes the economy more leveraged and makes it essential to keep home prices high, which means economic growth cannot be allowed to falter,  handcuffing the Fed. In times of inflation, financial markets become far more volatile, subject to more frequent and sharper zigs and zags.

When real interest rates are negative and inflation is heating up, the Fed (theoretically) can simply raise rates enough so that real rates turn positive. Today, turning real rates sharply positive would be a disaster because the property market thrives on negative real rates and drives consumption and economic growth. This in turn, however, is inherently inflationary.

Because of the huge overhang of US consumer debt, the primary concern of Mr Greenspan is to keep home prices high and that is the real reason why the Fed purposely is 'behind the curve'. The Fed is  likely to keep 'real rates' negative for much of the time in coming years and investors need to adjust to this new reality.

Michael Preiss is chief investment strategist at CFC Securities



Fed maintains inflated view of US economy