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Economics Weekly: Interest rate decisions to the fore but credit squeeze remains

Economics Weekly   1 October 2007


Interest rate decisions to the fore but credit squeeze remains


Rate cut expectations have not gone away...

Expectations about interest rate cuts remain intense in the wake of the rate cut in the US, but the UK and EU-13 economies are showing stronger growth overall than the US and a rate cut as a result of the sub prime crisis therefore seems unlikely. However, interbank rates in the UK and eurozone remain high relative to official short term interest rates, so rate cuts cannot be entirely ruled out if conditions in the real economy took a sudden turn for the worse. There are a few signs that the credit squeeze amongst banks, still so evident in the interbank market, is easing but it remains wide by historical measures, by the order of 3 to 4 times the average in the UK. This translates into a current spread of 55 basis points - 6.3% libor versus 5.75% base rates – compared with the usual 16 or so basis point spread. What will economic indicators due out this week mean for these trends?


...because interbank spreads to central bank reference rates remain wide, in the US...

It is interesting that although the cut in US Fed funds interest rates has reduced the US three month interbank rate or libor to 5.23% from nearly 5.8% at the end of August, the gap with the Fed funds rate remains wide, at around 48 basis points, just 10 basis points or so lower from a month ago. This means that despite the cut in interest rates of 0.5% to 4.75% and the addition of substantial liquidity, the US interbank market remains frozen. The reason is that banks remain worried about lending to other banks that may have undisclosed bad debt related to the sub prime housing sector on their books. This argues against further cuts in official interest rates in our view, as outside of the residential housing market related sectors US  economic growth is holding up very well. Indeed, final figures for gdp in Q2 highlighted last week that the economy expanded by 3.8% in annualised terms. Indications for Q3 suggest that consumer spending expanded by 3%, implying, given that it accounts for a two-thirds share of gdp, that the economy grew by a further 2 ½% or so in that quarter. Whilst the Fed’s favourite measure of price inflation slowed to 1.8% in the year to August, as an offset, unit labour costs rose by 4.6% in the year to Q2. But crucial data released in the US this week will show that the labour market is resilient. After a fall of 4,000 in August in non-farm payrolls, our view is that there was a rise of 100,000 or more in September. Retail sales growth remains strong and manufacturing output growth is firm. This does not suggest to us much scope to cut Fed funds rates further, even if interbank market rates remain relatively high compared to official rates. But the dollar has weakened in the face of rate cut speculation and is likely to stay weak until it is clear that the housing market is not impacting the rest of the economy and the freeze in the interbank market is thawing. well as in the euro zone...

In the euro zone, the interbank market also remains gummed up, with wide spreads persisting. Hence, the ECB is still injecting liquidity. But inflation data for September showed that CPI was 2.1%, above the 2% target. Offsetting that perhaps were lower figures for business and consumer confidence, though still suggesting strong economic expansion. On balance, the ECB will in our view keep interest rates on hold for the rest of the year but will move to raise rates next year. Money supply growth remains strong, at 11.4% on a 3 month year on year basis in August and PMI’s for services and manufacturing suggest continued healthy expansion. Data this week will likely show that unemployment is still low and falling and that retail sales continue to rise.


...and in the UK

UK house prices are showing some modest signs of slowing down, but overall the housing market has been resistant to higher interest rates thus far, including to higher interbank interest rates. Retail sales growth is so far proving resistant to higher rates as well, and in August there was a rise in the volume of sales of 0.6% or 4.9% year on year. Moreover, the latest CBI survey of retailers showed that a strong positive balance expect sales to remain robust into the autumn. Further to this generally strong economic growth background, concerns that price inflation will rise above 2% unless the economy slows further means that the Bank of England will leave rates on hold in October at 5.75%. However, wage inflation is low and this means that an economic slowdown in 2008 that results in sub 2.5% annual growth will keep downward pressure on wage inflation. This will likely convince the MPC to cut interest rates in 2008, perhaps as soon as February. A cut this year seems unlikely, however, as economic growth was 3% in Q2, while PMI’s suggest that it remained robust in Q3 so far and the housing market and money supply growth remain robust. Figures this week are likely, however, to show modest falls in the PMI for services and manufacturing in September from recent strong numbers, indicating a likely slackening in the pace of growth in the quarter ahead. And data for household borrowing and mortgage approvals and net unsecured household borrowing should show some weakening, though this is still modest. None of this will warrant a cut in rates by the MPC, but the vote this time to hold rates may not have been unanimous. More than 1 member may have voted for a cut, given that interbank rates still remain higher than implied by base rates. We shall find out the voting pattern in two weeks time when the minutes are published.


The conclusion has to be that this credit squeeze will not be resolved quickly. Cutting official interest rates and adding liquidity do not seem the solution. Our view is that it will take greater transparency and more information about which firms are sitting on bad debt before this credit crisis will be resolved. In the mean time an economic risk is that official interest rates are cut too sharply and too much liquidity injected, which leads to future price inflation, hence we will watch central bank meetings and comments closely for official views on these issues.


Trevor Williams, Chief Economist


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


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