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Monday April 16, 2007 - 10:19:14 GMT
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Forex Market News - Economics Weekly: Why the next move in US interest rates may not be down, Weekly economic data preview: Did any UK MPC members vote for a rate hike in April?

Economics Weekly:

Why the next move in US interest rates may not be down
Financial markets got a shock this month with the release of data that showed a very strong US labour market. But that did not change the market perception that US interest rates will be cut before the end of 2007, see chart a. We disagree with this and look for US interest rates to remain unchanged through the year, and believe that there is even a risk that rates may have to rise, especially as the year end approaches without there having been any rate cut in the interim.

Economic growth in the US looks strong...
Our view is predicated on the economic trends we are currently seeing persisting and evolving as we think likely through 2007. Chief amongst these indicators are labour market figures that we believe show the strength of US demand conditions more clearly than many other economic data because they reflect the actual decisions that companies make based on their real business experience and expectations. Chart b shows that unemployment has fallen sharply since 2003 and this has continued into 2007. The chart also shows that wage inflation has risen steadily since 2003, from an annual rate of around 1½% to above 4% presently. Our view is that this mix will not change unless unemployment rises sharply – in short, there is not likely to be any slowdown in the rate of growth of US wage inflation based on these current trends, thereby threatening price stability.

Chart c shows that whilst US economic growth has eased, it has not slowed that much from its 2004 peak. And although price inflation has weakened; this slowdown appears to have reversed in the last six months. Part of the reason may be that overall monetary policy is still loose, as long term interest rates have not risen, resulting in an inverted yield curve at present (long term rates below short term rates), chart d. This latter situation is usually regarded as suggesting recession, but in our opinion is a reflection of abundant liquidity and a market view that the US housing market slowdown will hit growth, employment and inflation later in the year. This is of course not an unreasonable assumption to make, but it has not happened yet. Indeed, chart e shows that the US housing market may be in the early stages of recovery rather than heading further into recession.

...despite housing market weakness...
This implies that the hit to consumer spending from lower housing market wealth is being offset by faster growth in earnings and by a rise in stock market wealth. Chart f shows that there has been a strong recovery in US equity markets, taking them back close to their all time highs overall. This is not suggesting that corporate sector earnings are expecting recession conditions, as the inverted yield curve in chart d implies. monetary policy is not as tight as many think and there is little spare capacity...
What are possible reasons why US economic growth may not slow by enough to weaken inflation significantly? After all, as chart g shows, US price inflation pressure seems to be on the rise, with hourly earnings, producer prices and core consumer prices all heading higher. One possible factor is the real stance of monetary policy relative to economic activity. Another is the amount of spare capacity in the US economy. Our view is that there is no spare capacity left in the US after the sustained recovery since the 2001 recession. This means that economic growth has to be well below 3% for some considerable time for inflation pressure to abate, and chart c shows this has simply not been the case. The point about the balance of the monetary policy stance is shown in chart h, which compares nominal gdp growth with nominal short term interest rates. When nominal interest rates are above gdp growth, then monetary policy is exerting downward pressure on economic activity through credit and monetary channels, when the reverse is the case then the opposite is true. The chart shows that despite the interest rate increases since 2004, the stance of monetary policy in the US could still be deemed loose or at least not tight. We believe this is why there will be no crash in the housing market, unemployment remains low and inflation has not fallen more meaningfully.

...with this in mind the Fed may not cut interest rates and inflation may not fall
But the key question is what will happen to Fed policy on interest rates if, as the year end approaches, inflation still remains elevated but the drag on consumer spending fades as the housing market recovers and investment spending starts to rise in response to continued economic growth? This is not to say that rates will inevitably rise, but with oil prices no longer low either and a risk that unemployment may have fallen further, US interest rates may not be cut in 2007 and the next move could be up rather than down.
Trevor Williams, Chief Economist

Weekly economic data preview

Did any UK MPC members vote for a rate hike in April?
• With financial markets confident of an interest rate hike in the UK within the next two months, the minutes of the April MPC meeting will be eagerly anticipated on Wednesday. After the surprise last month - the March MPC minutes showed an 8-1 vote for unchanged rates but with Blanchflower advocating a cut - could another surprise be on the cards? We expect a split vote in April, with the majority in the unchanged camp, Blanchflower still favouring a reduction and possibly two members calling for a hike. However, we believe that even a 8:1 result in April does not preclude a hike to 5.50% in May.

• It is also a key week for economic data in the UK. We expect the figures to underline the risk of higher interest rates in May. CPI inflation may have accelerated to 2.9% in March, average earnings growth may have ticked higher in February and retail sales are expected to have kept firm in March.

• CPI inflation and retail sales data will also take centre stage in the US this week and should show why interest rates are unlikely to be cut there anytime soon, despite financial markets still expecting a cut later this year. 'Core' CPI inflation is forecast to have remained at 2.7% in March, well above the Fed's implicit comfort range, and we expect a rebound in retail sales in March after a soft start to the year. Housing market figures and the latest Treasury capital inflows data will also draw attention.

• It is a quiet week for euro zone data, headed up by the German ZEW survey on Tuesday. We expect another modest rise in the economic sentiment index to 7.0, underlining the fast growth at the start of 2007 and the risk of a rate rise in June. There are a host of ECB speakers this week, with president Trichet a frequent guest. The first round of the French presidential elections takes place on Sunday.

This is a busy week for key UK economic data that could have significant implications for both forex and interest rate markets. The strong prospect of a further 0.25% hike in Bank rate to 5.5% over the coming months has helped to underpin sterling recently and pushed gilt yields higher. The latest outturns for CPI inflation, average earnings growth and retail sales this week, together with the minutes of the April MPC meeting, on Wednesday, will be closely scrutinized to assess the timing of any future rise. We expect the data this week to underline the prospect of higher interest rates, with our view that a hike to 5.5% in May is strongly likely. Annual CPI inflation has accelerated in the last two months and we expect a further rise to 2.9% in March, from 2.8% in February, on the back of higher oil prices and the impact of the 2007 Budget. The MPC may have had a preview of the data at their April meeting, if so, the annual rate is unlikely to be higher, given they chose to keep interest rates at 5.25%. One of the main concerns of the MPC is the likely pace of wage growth in 2007. Anecdotal and survey evidence suggest earnings growth has picked up and this should be reflected in the labour market data on Wednesday. This report is also expected to show a further 5,000 fall in the claimant count in March. Survey evidence suggest that high street sales remained firm in March, supported by rising house prices and buoyant employment. We expect retail sales to have risen by 0.5% in March, it could be stronger.

The minutes of the April MPC meeting on Wednesday will also attract a lot of market attention this week. However, we believe that they may offer few clues about whether the MPC is likely to raise rates in May. The voting pattern will be interesting, and clearly if the decision to maintain Bank rate was closer than in March then that raises the chances of a hike in May. However, an 8:1 vote as in March we believe still leaves a rate hike in May as the most likely outcome. We expect to see a split vote, with possibly up to two members voting for a hike and Blanchflower still favouring a reduction.

Inflation figures also head up the calendar in the US this week. Higher oil prices may have pushed annual CPI to 2.8% in March, from 2.4% in February. 'Core' CPI may have stayed at 2.7% for a third consecutive month. After two weak months, retail sales are expected to have rebounded in March, underpinned by rising earnings and employment. US housing starts recovered from a nine-year low in February, but may have eased back slightly in March. A sharply weaker figure could elicit strong financial market reaction. There are a host of Fed speakers this week.

Economic data from the euro zone is unlikely to get much market reaction this week. The German ZEW survey, on Tuesday, is the highlight. Speeches by ECB members may offer little additional insight on the outlook for interest rates to that offered at last week's ECB press conference.
Jeavon Lolay, Senior Economist
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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