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Monday September 10, 2007 - 11:23:39 GMT
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Economics Weekly - High interbank rates could impact the economy; Weekly economic data preview - UK data, Fed and ECB speeches in focus

Economics Weekly 10 September 2007


High interbank rates could impact the economy


Economic impact of high libor rates

The rise in commercial banks' libor rates (London Interbank Offer Rate - the rate at which banks lend money to each other) has tightened monetary policy without central banks having to raise official interest rates. Higher libor rates could eventually be passed on to households and companies in the form of higher borrowing costs, and so weaken economic growth. We investigate the likely impact of high libor rates on the UK economy in 2008 and 2009, if the current liquidity freeze lasts.


Libor rates are high everywhere, not just in the UK

Despite a huge injection of funds by the US Fed and the ECB, interest rates in the markets where banks lend money to each other remains well above base rates, and well above their historic averages relative to base rates. Chart a shows that UK libor rates are well above US ones, and above ECB rates. However, that may be more because of the different path of the respective economies, which has resulted in 4% repo rates in the eurozone, 5.75% in the UK and 5.25% in the US. But table 1 shows quite clearly that libor rates have increased the most in the UK since June, up by 106 basis points with a rise of 36 in the US and 64 in the eurozone. Would cutting base rates help to reduce these rates? The answer may be no.


...despite huge injections of liquidity, it appears to be worries about who holds sub prime debt that is leading banks to hoard cash

Libor rates are suggesting that there is a credit problem, as UK M4 money supply growth is expanding by 13% a year and central banks in the US and the ECB have injected a huge amount of liquidity into the money markets yet there has been no fall in their libor rates – in fact, they have risen further. Chart b shows that libor rate spreads to overnight rates remain extremely wide, and in the UK, is at the widest relative to the overnight rate in the UK, where the central bank has done least to inject liquidity into its interbank money market. The reason the Bank of England gives is that it is not its obligation to keep libor rates in line with Bank Rate.


But what would be the impact on the economy if libor rates remained at current high levels into 2008?

We have put together an economic scenario where libor rates move in line with the current market-based path for 24 months, taking it out to 2009. This is called the extreme case. In the moderate case, we have assumed that libor falls more rapidly than is implied by the extreme case, and then continues to fall in reaction to the economic impact of the earlier high rates. In the base case, we keep libor on the path of our central view on UK Bank Rate.


Scenarios show that growth would be badly hit if libor rates do not fall back and lenders pass it on

Chart c shows three different scenarios for UK libor. In chart d, economic growth is clearly hit quite badly by the high level of libor, assuming it is passed on to borrowers. 6.8% libor rates would result in UK economic growth of just 1.7% in 2008, falling further to 1.5% in 2009. Consumer price inflation would fall to 1.7% in 2007 and 1.5% in 2008, see chart e. Since this is well below the 2% inflation target, it clearly implies that base rates would have to be cut by up to 1% to ensure inflation keeps close to the 2% target. In fact, what chart d shows is that, even if interest rates were to fall back quickly to the same libor path as expected in the base case, economic growth would still slow, though only to 2.3%, and inflation would still be around the 2% target. But the scenarios show that UK base rates of 6.3% or higher would inflict serious damage on UK economic growth in 2008 and probably lead to an even bigger cut in the Bank Rate next year than in our base case. If this view is correct, an obvious strategy would be to lend out long on the libor curve, assuming short term funds are available to support the position.


Trevor Williams, Chief Economist


Weekly economic data preview


UK data, Fed and ECB speeches in focus


The focus this week will be on economic data from the UK and the US, and speeches by Fed chairman Bernanke and ECB president Trichet. UK data this week includes producer prices, foreign trade and unemployment. Interest rates are expected to rise to 2.75% in Switzerland but stay unchanged at 8.25% in New Zealand. Revised Q2 gdp data and machinery orders are due from Japan and may impact expectations of BoJ monetary policy.


• The high level of money market rates was responsible last week for the ECB to delay a previously pre announced rate increase. A 9-year high in UK Libor separately led the BoE to leave base rate on hold but take the unusual step of issuing a statement on what it thought of the implications so far of the credit turmoil for the economy. The conclusion in both cases of the BoE and ECB is that they need time to fully understand what the possible toll will be of the credit turmoil on the economy and the implications for inflation and growth. Looking through the uncertainty, we are confident that UK rates have peaked but believe that the ECB is still on course to raise rates to 4.25% once financial market conditions normalise. Smaller countries like Sweden and Switzerland are not isolated from events in the major markets but with their interest rates still relatively low with respect to growth and inflation trends, it should be no surprise that Sweden raised rates last week and that Switzerland may do the same this week.


UK producer prices for August kick off a busy week for indicators on Monday. Output prices are forecast to have increased by 0.2%, the smallest rise since December last year. This should leave annual PPI inflation a touch higher compared to July at 2.5%. Foreign trade data for July will be published on Tuesday and is not expected to show a major change from June. We expect the global deficit to have stayed close to £6.3bn. Unemployment data for August is due on Wednesday and may turn out to be one of the most interesting UK releases of the week. Despite the ongoing tightening in the labour market, the claimant count rate has declined in each of the last 10 months (see chart below), wage inflation continues to be surprisingly benign. Average earnings growth slowed to just 3.3% in July, the lowest level in 4 years and more than one percentage point below the BoE reference target of 4.5%.


• A speech by Fed chairman Bernanke on Tuesday titled: "Global Imbalances: Recent developments and their Implications" heads up the calendar in the US and is almost certain to fuel the debate about whether interest rates will be cut or not on September 18th. More evidence of slowing employment growth last Friday increased the likelihood of a 0.25% rate cut this month, but with less certainty than the 100% odds priced in by the futures market. This is at odds with Fed policymakers who have not spared any occasion to emphasise that the US economy outside of real estate is still in fairly good shape. In this respect, the release of retail sales and industrial production for July on Friday could help some FOMC members to assess their opinion on the outlook for economic activity. All things considered, the Michigan consumer confidence survey on Friday could overshadow all other releases this week given the Fed's current focus on the timeliest indicators and anecdotes. The survey may indicate to what extent tighter lending conditions are sapping confidence.


• A fairly quiet week in terms of economic data is unlikely to make ECB officials wiser about the possible ripple effects from higher inter-bank lending rates on the real economy. This will put attention on comments by ECB president Trichet at the BIS on Monday and at the European Parliament on Tuesday for an extraordinary hearing on the sub-prime mortgage crisis. Final euro zone inflation data for August on Friday is likely to confirm the preliminary estimate of 1.8%, keeping inflation below the ECB target for a 12th consecutive month.


Kenneth Broux, Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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