The recovery of the US economy during the first quarter of this year has been so spectacul

ar that it is creating a new set of risks for financial markets. The great new risks now facing the US economy center on monetary policy and the oil market. The current federal funds interest rate of only 1.75 percent has clearly become unsustainable in view of the economy's resilience. The Federal Reserve will raise interest rates by at least 0.25 percentage points during the second quarter and could increase short-term interest rates to at least 3 percent before the antumn-the level they were at before September 11.

Such tightening would probably cause refinancing to slump to about ＄300 billion at annual rates late this year, which would eliminate capital gains as a prop for consumer spending. Rising interest rates could also damp the rally likely to occur in the equity market as corporate profits recover. If investment spending fails to revive, the economy's annual growth rate could slide back to the 2～3 percent.

The oil price is also a big risk, mainly because the Bush administration appears determined to attack Iraq. The probability of war could easily push the oil price back into the ＄35～＄40 a barrel range for at least a few months. In effect, that would impose a big new tax on consumer spending and corporate profits. The prospect of monetary tightening and a sharp increase in the oil price suggests that late 2002 and early 2003 could be a period of great volatility for the US economy.