Steady as she goes is the message on rates
Last month the ECB announced a rise in official interest rates of 0.25% to 4.25%, in response to what it saw as the growing upside risks to price stability.
There is no expectation of any policy change this month but markets will monitor the post-meeting press conference to see what the ECB’s take is on the latest round of eurozone sentiment and activity indicators, which suggest that the economy is losing considerable momentum.
Meanwhile, there will be much interest in Thursday’s Bank of England announcement, after the minutes of the July meeting revealed a three-way split amongst policy committee members, with one member voting for a rate cut, one for a hike and the remaining seven going for no change.
The overall tone of the minutes indicates that the Monetary Policy Committee (MPC) remains in a relatively hawkish mood, with the majority believing that the upside risks to inflation had intensified. At the same time, however, events over the past month leave us more convinced that British rates remain on hold for now as the trade-off between growth and inflation continues to deteriorate, making life very difficult for the MPC.
The British consumer price index (CPI) rose to 3.8% in June, with additional upside pressure expected over the coming months.
Measures of producer output inflation are running at record high levels, while survey-based measures of inflation expectations have picked up.
Activity data, meanwhile, indicates that the downside risks for the economy have also intensified. The first estimate of second-quarter GDP shows that the economy grew by 0.2%, compared to 0.3% in the previous period. This represents the weakest outturn since early 2005. As a result, the year- on-year growth rate decelerated to 1.6%, down from 2.3% previously and 3.3% in the same period in 2007.
Leading indicators suggest further weakness in the months ahead. Both the manufacturing and services PMI’s are at their lowest levels since 2001, with current readings suggesting that the pace of economic activity is close to stagnant.
Spending on the High Street appears to be cooling, with the volume of retail sales falling a record 3.9% in July. Consumer confidence appears to be in free fall, while real income growth is weak, personal savings are low and household asset wealth is falling.
The outlook for the housing sector remains gloomy with all key house price surveys showing prices falling on a year-on-year basis. Banking data suggests further weakness ahead as households face tighter credit conditions, with mortgage approvals down over 68% year-on-year.
There is some speculation in the marketplace that given the inflation problem, the Bank of England could hike interest rates before year end. Such talk is helping to put a floor under sterling versus the euro and dollar. However, we see the next move in rates as being downward, though this is unlikely to happen until the inflation situation improves.
We estimate that the British economy will grow by just 1.6% this year, down from 3.1% in 2007. Below trend growth should help drive British inflation lower in the medium term, facilitating an easing in monetary conditions. However, with inflation set to rise towards 4% in the months ahead and remain above target over the balance of the year, this will constrain the ability of the MPC to act in the near term. Thus, we envisage a period of steady rates over the remainder of 2008 but see scope for rate cuts coming back onto the agenda in the first half of 2009 as the CPI rate falls back.
* John Beggs, chief economist, AIB Global Treasury
