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Thursday December 8, 2005 - 13:58:12 GMT

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Where next for interest rates?

The US Federal Reserve is likely to increase rates again to 4.25% in December, but the January decision will be close and there is likely to be a pause soon as underlying inflation should stay under control while the economy is likely to cool. There is also a 30% chance that there will be no rate increase during 2006.

The ECB is likely to sanction a further 0.25% rate increase to 2.50% in the first quarter of 2006 with a further increase realistic during the second quarter.

The Bank of England is likely to keep rates on hold at 4.50% for the next 2-3 months and potentially throughout the first half of 2006. The Bank of Japan is likely to tighten policy in March/April 2006, but interest rate increases will be slow. There is a strong probability that the Swiss National Bank will tighten in December and could sanction a 0.5% increase with a further rise in rates likely at the March meeting.

United States

The US Federal Reserve has increased interest rates at successive FOMC meetings to 4.0% from lows of 1.0% in 2004. The latest economic data shows that the economy is still performing well with solid growth in most sectors. Consumer confidence has recovered, but there will still be uncertainties over spending levels during the next few weeks at least. There is also likely to be major uncertainty surrounding the housing data, especially as recent evidence has been contradictory. Overall, with interest rates higher, there is likely to be a slowdown in the housing sector and this will create caution within the Federal Reserve as it will have a significant impact on consumer spending.

Headline inflation is still being pushed up by the strength of energy prices seen in the third quarter, but the headline inflation rate should fall this month and the key issue is whether there will be an impact on core inflation. So far, the evidence suggests that that the developments are still relatively favourable as the core inflation reading in the GDP report fell to 1.2% from 1.3% while the October core PCE deflator within the personal spending data fell to 1.8% from 1.9%.

The Fed will need to be forward looking on policy as the rate increases already sanctioned will not have their main impact until later in 2006. This is an issue within the Fed, illustrated by the November minutes where some members expressed concerns that policy could be tightened too far. During 2006, the Fed will have to be much more responsive to on-going economic trends and will not be able to tighten in a mechanical fashion.

The new Fed Chairman will take office at the end of January and Bernanke will want to maintain policy stability. Bernanake will also be reluctant to take a soft stance early in his tenure and there will be a reluctance to stop interest rate increases as soon as he takes office as this could undermine confidence in his inflation-fighting credentials. The equation will, however, be very different by then if the economy is slowing, especially if the housing sector is weakening. The risks of a slowdown will increase during 2006 as a whole. Given the net economic risks, the Fed is unlikely to tighten beyond the second quarter of 2006.


The ECB sanctioned a 0.25% rate increase in December to 2.25%, the first increase in rates for five years.

The evidence suggests that the Euro-zone economy is generally stronger, led by strengthening industrial exports, although conditions remain patchy with particular doubts over consumer spending. The ECB will be concerned over inflationary pressure, although the headline rate should come back to near the 2.0% level as energy price increases come out of the annual calculations. The bank’s principal fear is likely to surround the rate of monetary creation, which is running above long-term comfort levels, and this will encourage the bank to remove the degree of policy stimulus.

There is little need for an aggressive tightening from the ECB and there will be the risk of divisions within the ECB given the differences in national performances. Nevertheless, increases of 0.50 - 0.75% are realistic in 2006 as a whole.


The Bank of England cut interest rates to 4.50% from 4.75% in August, but has been happy to keep rates on hold since then with unanimous decisions from the MPC.

The latest evidence suggests that the housing sector and consumer spending have stabilised at weaker levels and could be recovering slightly. The Bank of England will be concerned over inflation, with particular concerns over forthcoming wage negotiations. The bank will not, therefore, want to be seen as taking chances on inflation as this would have serious medium-term implications. The weak industrial production data will raise concerns over the economy and there will be pressure from the manufacturing sector for further cuts in interest rates.

Overall, given the uncertainties, the Bank of England is likely to be content to leave rates on hold until at least February.


The Swiss National Bank is concerned over the risk of higher inflation in the economy and considers policy too expansionary. The latest economic data has offered evidence that the economy is strengthening with a sharp gains in the leading indicators and firm growth.

In this environment, the central bank will want to tighten policy. An increase in rates is highly likely at the December quarterly meeting and there is a possibility that the central bank will sanction a 0.5% rate increase. Monetary tightening is likely to continue during 2006.


The Bank of Japan is more confident that deflationary pressure is easing and that the economic recovery is on a sounder footing. Core consumer prices are likely to move into positive territory over the next few months, although the situation will be complicated by the fact that oil prices are likely to be excluded from the calculation. In an environment of stronger growth, easing deflation and a weak currency, there will be increasing pressure for the very lose monetary policy to be tightened.

There will be further pressure on the bank from the government to delay a monetary tightening, but a gradual move is likely from March/April 2006.


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