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Monday July 31, 2006 - 10:52:28 GMT
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Economics Weekly:Risk of higher interest rates in the euro zone and Australia, UK on hold

Central bank decisions in the UK and euro zone and the monthly US employment report will take centre stage in financial markets this week.
The probability of an interest rate rise in the UK has inched up in recent weeks following a series of strong economic data. Annual CPI inflation accelerated to 2.5% in June, matching the September’ 05 high and moving further away from the BoE’s 2.0% target. Economic growth was 0.8% in Q2, the fastest pace in two years and above trend pace for the third successive quarter, adding pressure on resources and eroding spare capacity. Recent news from the housing market has also been surprisingly strong. So why do we expect the BoE to hold rates at 4.50% this week? One key reason is that the minutes of the July MPC meeting showed an unanimous 7-0 vote in favour of no change in interest rates, with committee members identifying both upside and downside risks to inflation. In addition, the May Inflation Report showed an elevated profile for CPI inflation in the short-term, so the latest June figures merely confirmed the spring projection. What could determine whether the BoE reverses the rate cut of August last year, is the new inflation path presented in the next Inflation Report. The Report will provide a detailed analysis and updated forecasts for UK growth and inflation and will be available to committee members ahead of its general publication date on August 9. Although we would not be overly surprised by a hike this week, in the face of recent data, we believe the MPC can bide its time until later in the year.

The outcome of this week’s ECB meeting appears more straightforward. Interest rates in the euro zone remain historically low, especially in real terms. EU-12 M3 money supply growth was 8.5% pa in June, well above the 4.5% level considered by the ECB as consistent with its 2% inflation target. The ECB is keen to bring it under control and inhibit any spill over into inflation at a stage where economic growth is more broadly based. With inflation no longer forecast to meet the 2% target this or next year, further rate hikes seem assured. ECB president Trichet signalled a move for this week when he reinstated the phrase ‘strong vigilance’ into his communiqué at the July press conference and confirmed that the ECB governing council would now meet physically on August 3rd instead of holding a traditional teleconference. This suggests that a broad consensus has been reached to hike rates by 25bp to 3%, the fourth rise since last December.

Higher interest rates too are on the way in Australia. The RBA has kept interest rates on hold since May, but we expect the bank to tighten policy by 25bp to 6.0% on Wednesday following stronger than expected inflation data last week. Core annual CPI accelerated to 2.9% in Q2 and threatens to breach the RBA's upper target ceiling of 3%, if left unchecked by higher borrowing costs.

In the US, the employment report for July on Friday may provide some assistance in settling the outcome of the August 8 FOMC meeting. We expect non-farm payrolls to have increased by 130,000 in July and the unemployment rate to have remained stable at 4.6%. The result should confirm the slowdown in job creation in Q2 underscored in last week’s Beige Book. However the risk of higher wage growth may overshadow the release and could keep the odds of an 8th August rate hike evenly balanced.

Jeavon Lolay, Senior Economist
Kenneth Broux, Economist
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