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Economics Weekly - Is there a 'right' level for interest rates? Weekly economic data preview - UK Pre-Budget Report and US Fed FOMC minutes in focus
Economics Weekly 8 October 2007
Is there a 'right' level for interest rates?
Will interest rates be cut soon in the other major economies?
There is plenty of debate about where interest rates should be following the sub-prime inspired credit crisis in the US, which has raised lending rates more than intended by central banks in some of the major economies. In response, the US central bank has already cut interest rates by 0.5% on 18th September, taking them down from 5.25% to 4.75%, the lowest rate in just over a year. Will further rate cuts follow? That seems to be the view of the futures markets for Fed funds, which have priced in a rate equivalent to 4.25% by December 2007, see chart a. It is noticeable, however, that the chart shows that interest rate cuts are also expected in the UK and Eurozone. This is partly because the continued high levels of current interbank rates are making future rates look low, but even taking this into account, it does appear that financial markets are expecting other central banks to follow the lead of the US, as they did after the 1998 LTCM crisis (when the Fed cut rates by 0.75%). But will that really occur this time? Our view is that it will not and that the UK and European central banks will take their own path and not follow the US. We lay out some reasons why the US will not be emulated, we even doubt whether the US can sustain further rate cuts without taking much greater risk with inflation this time than in 1998.
â€˜Realâ€™ interest rates suggest that rate cuts are possible in the US and eurozoneâ€¦
Measures of real 3 month interest rates (nominal interest rates adjusted for consumer price inflation) show that, for the US, they are higher than either the 20, 10 and 5 year averages, see chart b. This suggests that interest rates can be cut aggressively. But the experience of 40 years shows that this should be done only if price inflation behaves as benignly as it has done in the last decade or so rather than the longer term. Recent data suggest, if anything, that inflation in the next decade will not be as low as in the last decade, implying a need for more cautious monetary policy going forward to keep inflation in check. But real interest rates are above the 20 year average, supporting the recent Fed rate cut and market expectations that further cuts could be in the offing. Chart c shows that real interest rates in the UK are below 10 and 20 year averages, but above the 5 year average. This suggests that monetary policy will have to be tightened further, if inflation does not fall back and stay as low as expected, for instance because of weaker economic growth. Since we believe that growth will weaken, interest rates could still be cut, but not until 2008. For the eurozone, the real rate analysis suggests that the ECB has got its policy stance wrong and hence that there is plenty of scope to cut interest rates, as real rates are well above the 5,10 and 20 year averages, see chart d.
â€¦but economic growth relative to real interest rates suggests little scope for reductions What about real economic growth rates relative to real interest rates? For the US, chart e shows that monetary policy is tight and interest rates are bearing down on economic activity. This will remain the case until real economic growth rebounds. If growth does not rebound, then the Fed could, and likely will, cut rates, perhaps down to the 4.25% predicted by the futures market. For the UK, the relationship between growth and interest rates suggests that rates could be raised quite aggressively, see chart f. But we would argue that this is misleading as growth is highly likely to weaken soon. But it does highlight the risk that if growth does not slow, the UK monetary authorities do not have much scope to cut interest rates. Eurozone interest rates are about right on this analysis (see chart g), but with an upward bias.
The Taylor rule is clearer: inflation remains a risk and there is no room to cut rates in the major economies
What about the best known measure of the appropriate official monetary policy stance, the Taylor rule? Using this rule, which takes account of economic capacity, real interest rates and the performance of inflation relative to its target and gives a clear picture of official interest rate policy, the US monetary authorities look to be taking risks with inflation by cutting rates as shown in chart h. Although declining, there is little scope to cut rates unless the economy slows; suggesting that the recent cut in Fed rates may be reversed quite quickly should the economy not slow as expected. For the UK, chart i shows there is some modest scope to cut interest rates, but it does not suggest that the MPC should rush to do so. For the euro zone chart j suggests that interest rates will rise further, perhaps up to 4.5%, but this does not have to occur in the next few months. All in all, these conclusion run counter to the current market view as expressed in chart a, of cuts in the US, UK and Eurozone interest rates next year. Our forecasts only show rate reductions in the UK in 2008, as economic growth slows.
Trevor Williams, Chief Economist
Weekly economic data preview
UK Pre-Budget Report and US Fed FOMC minutes in focus
A relatively quiet week lies ahead in terms of economic data and central bank decisions in comparison with last week and this will allow market observers to digest recent trends and what these imply for the latter stages of 2007. The positive US employment report last Friday tempered speculation that the US Fed will cut interest rates again at the end of this month. With this in mind, markets will scrutinise comments by Fed speakers, including chairman Bernanke, and the September FOMC minutes for guidance on the outlook for rates in Q4. Data in the UK this week includes producer prices and industrial output on Monday and foreign trade on Tuesday. The RICS will report the results of its September house price survey on Thursday. Chancellor of the Exchequer Darling will present his first Pre-Budget Report on,Tuesday where he may decide to scale back the forecast for 2008 gdp growth. Foreign trade, retail sales and consumer confidence are due in the US and \ may help to finalise estimates of Q3 gdp. In the euro zone, markets will concentrate on the testimony by ECB president Trichet on Thursday. Futures markets scaled back expectations last week of a rate rise after a change in the bank's rhetoric. The Bank of Japan is forecast to leave interest rates at 0.5% on Thursday.
â€¢ The decision by the BoE last week to keep base rates on hold at 5.75% surprised nobody as the bank decided that it needs to collect more information in the run-up to the Inflation Report next month. This will provide an update on where the Bank thinks economic growth and inflation are headed and to what extent it believes activity and demand will be dented by the global credit squeeze. Producer prices for September and industrial output for August are due on Monday. A rise in output prices in last week's PMI survey to the highest level in the survey history points to upward pressure and could result in a stronger increase in output PPI compared to August. Input prices are forecast to have rebounded by 1.5% from a 0.3% drop in August, supported by a 9.5% increase last month in the price of crude oil. The PMI last week reaffirmed the steady environment for manufacturing output, as did our own monthly Business Barometer. This explains why we are forecasting a rebound in output in August from July, led by higher production of capital goods where activity has contracted for the last two months. The British Retail Consortium will report the results of its September survey on Tuesday and this will help to shape opinion about consumer spending growth at the end of Q3. Foreign trade data for August is also due on Tuesday and is forecast to show no major variation from July with the global deficit expected at around Â£7.0bn. UK exports to the euro zone rose to the highest level in August in a year (Â£10.3bn), a trend we believe can continue given the depreciation of sterling vs euro in September to a 16-month low. The RICS last month reported the first negative balance between buyers and sellers since August 2005 and anecdotal evidence suggests we could see a negative outcome in September on Thursday for a second consecutive month.
â€¢ The US Fed FOMC minutes are due on Tuesday and will provide valuable information about what policy members think of the present balance of risks towards economic growth and inflation and to what extent they believe that the 0.5% rate cut last month was enough to contain the impact from the slump in residential property to the broader economy. Retail sales figures for September are due on Friday and will give an idea to what extent households are cutting back on discretionary spending in response to tighter credit and mortgage lending rates. Steady growth in real disposable income and personal consumption this summer suggest the US economy should be on target for average growth of around 2.5% in Q3. The Michigan consumer confidence survey for October is also due on Friday and will give a first glimpse of how spending may evolve in Q4. Steady growth in real wages suggest it will be well underpinned.
â€¢ A quiet week in terms of data lies ahead in the euro zone and this will keep the spotlight on the ECB. President Trichet is scheduled to make a number of appearances this week and after last week's shift towards a more neutral bias, markets will be on alert for comments on the economy that could change expectations for interest rate policy in the months ahead.
Kenneth Broux, Economist
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500
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