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Economics Weekly - Fed, ECB and BoE to hold interest rates on growth fears4

Economics Weekly 4 August 2008

Fed, ECB and BoE to hold interest rates on growth fears4

The US Fed, the ECB and the Bank of England are widely expected to keep interest rates on hold at 2%, 4.25% and 5%, respectively, this week. This is due to continuing signs of slow GDP growth, but rising inflation, in turn, is inhibiting cuts. Chart a below shows that real interest rates are already negative/low, therefore, likely to lead to stronger economic performance, as reflected in the pick up, albeit modest, in US GDP growth in Q1 and Q2 from contraction in Q4 2007. Key data this week are likely to show the US Fed's preferred measure of inflation, the core PCE deflator, rose at a monthly rate of 0.2% in June, up from 0.1% in May, reinforcing the view that the Fed holds a tightening bias and that their next interest rate move is likely to be upwards. However, US ISM and UK & EU-15 PMI services sector surveys may add to the gloom settling from last week's manufacturing survey releases. These service activity reports are again likely to be indicative of contraction, see chart b for past trends; suggesting that economic growth in the major economies is weak. The RBA is likely to hold interest rates at 7.25% this week.

UK data releases include industrial and manufacturing output for June and the services PMI survey for July. Data published last week showed the fourth successive monthly fall in the UK manufacturing PMI to 44.3 in July from 45.9 in June, the lowest outcome in almost a decade, and triggering fears that manufacturing could slip back into recession. However, our forecast is for industrial and manufacturing production to both rise 0.2% on the month, reflecting some rebound from sharp contraction in May, although recent weak survey outcomes suggest that the risk is to the downside. The PMI services activity report may also be indicative of contraction, although recent official output figures have been more positive. We forecast a modest fall in the survey index to 46.7 in July from 47.1 in June. HBOS house prices and the NIESR GDP estimate, both for July, are also published.

We expect EU-15 producer prices growth to show another strong monthly increase in June, raising the annual growth rate to 8.1% from 7.1% in May. In addition, German wholesale price growth could stay close to 9% on an annual basis. Therefore, both these figures will add to pressure on the ECB to raise official interest rates again as soon as possible. But for now, EU-15 retail sales remain weak, and likely to fall by 0.5% in June, representing a 1% decline on a year-on-year basis, highlighting a lack of confidence in the consumer sector, and providing justification for the ECB to keep interest rates at current levels for now. The EU-15 manufacturing PMI came in at 47.4 in July, as activity slumped to its lowest level in five years, with activity in France and Italy at levels closely aligned with recession. German activity held up at a level of 50.9, but factory orders are weak and data for June may disappoint. The final EU-15 services PMI should confirm activity at a level of 48.3, also indicating contraction.

In the US, June personal income and spending data will provide further information on the state of play in the consumer sector - we are predicting strong growth numbers partly due to tax rebates. Consumer credit growth of $8bn in June compared with $7.8bn in May should also support spending. The ISM manufacturing survey fell to 50 in July from 50.2 in June. The service sector index, published this week, could improve a touch to 48.5 in July from 48.2 in June, although this still indicates contraction. The Fed's preferred inflation measure, the core PCE deflator,= may have risen to an annual growth rate of 2.2% in June, from 2.1% in May, but growth in unit labour costs has slowed as jobs have been lost this year.

Nichola James
Senior Economist, Corporate Markets

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
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www.lloydstsb.com/corporatemarkets

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