Inflation fears may see interest rates rise again
In the US, the chairman of the Federal Reserve, Ben Bernanke, delivered his biannual testimony on monetary policy to the US Congress last week.
The Fed has kept interest rates on hold since last summer. However, it remains cautious about the outlook for inflation. At this point, the markets see only a small chance that the Fed will reduce the official Fed funds rate this year. The rate currently stands at 5.25%.
While US inflation is indeed easing, the downward trend has been modest and the risks of upside pressures still remain. Under these circumstances, the Fed has retained a tightening bias.
However, as the year progresses, the economy should weaken and inflationary pressures abate. There appears to be little risk, therefore, that the Fed will raise rates again. A more likely scenario is that policy will stay on hold until well into the second half of the year. However, I do not rule out a cut of 0.25% by mid-year.
In Britain, the Bank of England issued its quarterly inflation report last week. The bank, of course, surprised the markets by raising official rates by 0.25% to 5.25% in January. Since then, the annual rate of inflation has eased from 3% in December to 2.7% in January.
However, as the bank is concerned about the risks of an inflationary wage round, it remains vigilant. In its latest report, it stated that inflation would only stay close to the medium term target on the basis that official rates were at 5.5%.
It seems very likely, therefore, that the bank will raise official rates again, either in March or in April. After that, however, rates should go on hold for some time.
I believe that the British economy will experience a modest downturn in the second half of 2007. This could open the door for some reversal of rate towards the end of the year.
In the eurozone, European Central Bank president Jean-Claude Trichet set the scene at his last press conference for a fresh ECB rate hike in March. The official rate is expected to rise to 3.75% at the meeting on March 8. After that, it is expected that the ECB will still regard monetary policy as accommodative, implying that further tightening is in the pipeline. Another rate hike of 0.25% is forecast for June. This would bring official eurozone rates to a neutral level at 4%.
Where euro area rates go after mid-2007 depends on the health of the economy. There is no doubt that the euro economy is growing at a relatively fast pace. Growth reached 2.7% last year and could exceed 2.5% in 2007. Growth in the fourth quarter of 2006 came in at 0.9% quarter-on-quarter, which was much faster than expected.
Growth in excess of 2.5% will be seen as above potential by the ECB. It may lead the central bank to conclude that policy should become restrictive. If the economy continues to grow above potential, official interest rates could rise above the 4% forecast for mid year.
Central banks remained concerned about the risks to inflation from what are perceived to be ample global liquidity conditions and an appetite for riskier assets, such as property and equities. Part of this global liquidity story stems from the existence of very low interest rates in Japan.
The Bank of Japan will meet this week to consider Japanese interest rate policy. Rates could be raised from 0.25% to 0.5%. However, investors are still likely to borrow yen at low interest rates and swap these funds into higher yielding assets in other countries.
As such, key central banks will keep a close eye on the risks from global developments on their national inflation prospects.
John Beggs Chief Economist AIB Global Treasury
