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Economics Weekly: How much further will interest rates rise?

How much further will interest rates rise?
Will interest rates rise in June?
In June, a number of key central bank meetings are due to take place. Global interest rates are on a rising trend. This is being driven by evidence that faster economic growth and higher energy prices are leading to a rise in actual and expected inflation. But although the world economy is experiencing a period of synchronized economic growth (global growth is in its third year of plus 4% expansion), there are still significant divergences in rates of growth between different countries. These in turn lead to differences in inflation rates and so in interest rates between economies. In June, central banks in this analysis may be concerned by the rise in inflation, as shown in chart a. Moreover, falling or low rates of unemployment, shown in chart b, suggest that economic growth is solid. In this briefing, we look at where interest rates may be headed in four major economic zones based on a simple monetary policy approach.

Monetary policy approach suggests that the bias is for higher interest rates
When nominal short term interest rates are lower than the rate of nominal economic growth (volume growth added to economy wide inflation), monetary policy is loose. This is because credit creation and hence economic activity is encouraged when the cost of individuals or companies borrowing money is less than the growth of their nominal income, as implied by economic growth in the economy as a whole. The reverse would also be true, of course, with the further that actual interest rates are above nominal economic growth, the more restrictive is monetary policy. Neutral interest rates are therefore those that neither add to economic activity nor detract from it, i.e. match nominal economic growth exactly. We use this approach to help to assess the bias of monetary policy in the US, UK, euro area and Japan. In reality, given the time between a change in interest rates and its full effect being felt in the economy, there is no mechanical link between economic growth and interest rates and judgement about where the economy is headed can be more important than where it is currently. Nevertheless, this analytical approach provides useful insights into the likely size and direction of future interest rate changes.

So what does this approach tell about the current bias in monetary policy in some of the major economies?
Chart c suggests that the jury is out on whether US interest rates will rise any further in the current cycle. Although employment growth was weaker than expected in May and there are signs that the housing market is more subdued, price and wage inflation are pushing to the top of the Fed’s tolerance range. But if annual nominal economic growth does not slow in Q2 to 5% or below then the risk is that US inflation will continue to accelerate. In Q1, because of fast growth, the 'neutral interest rate' as we define it above, was 6.9%. Of course, economic growth is slowing so interest rates do not need to be at that level. But as chart c shows, US monetary policy has been loose for a long time and although is now much more in line with economic growth it is still loose and encouraging activity to accelerate at a time when there is little or no productive spare capacity left. This is evidenced by the rise in price and wage inflation. Hence, it will be a difficult balancing act for the Fed when it next meets on June 28/29. On balance, the data suggest that a precautionary rise in rates of 0.25% to 5.25%, depending on how the inflation figures between now and then behave, cannot yet be ruled out. For the UK, the interest rate decision will be much easier: keep them on hold. Chart d shows that nominal economic growth and interest rates are still aligned. Although there are signs that economic growth is accelerating- service and manufacturing output is picking up - it is not clear and unambiguous that this will not stall and so the central bank can afford to wait before acting. Moreover, unemployment is rising modestly and price inflation has only just risen to hit the 2% target. We still look for any base rate rise to take place later in the year, possibly October.

In the euro zone, the decision is also clear: interest rates will rise. Data for money supply and price inflation are rising fast enough to justify a continued gradual normalisation of interest rates. Whether they reach the 4% neutral rate should depend on whether economic growth stays strong. The worry is that in 2007 economic growth may slow, so lowering the neutral rate of interest. Germany and France, the two biggest members, are lagging the overall growth rate for the zone as a whole. And forecasts show that growth in both of these economies will slow in 2007. Unemployment in the euro zone, for example, still remains very high, albeit falling gently. For Japan, as chart f shows, interest rates are likely to be increased if the current growth trend persists, but there is no pressure for an immediate rise. Charts a and b are a reminder that Japanese price inflation is only just turning positive and its unemployment rate, though falling, is not down that sharply. This is not an environment where there should be sharp increases in interest rates.

Overall, our conclusion is that the bias of monetary policy in June is towards further hikes in interest rates, but only one central bank (the ECB) seems certain to do so in the month.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
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