Global Markets Weekly – 12^th February 2007

Key Macro economic developments

• Although the January rate hike in the UK demonstrated that central banks reserve the right to surprise the markets, the Monetary Policy Committee’s (MPC) decision to leave policy unchanged last week was generally expected and attention will now shift to the publication of the February Inflation Report on Wednesday. At present, it still remains unclear whether last month’s rate hike simply constituted the bringing-forward of planned monetary tightening, in a pre-emptive fashion, or an ‘extra’ hike in response to what certain MPC members may regard as a deteriorating inflation outlook. The updated growth and inflation projections in this week’s Inflation Report will provide a greater insight here, even if the apparent division within the MPC (as highlighted by the 5-4 vote last month) results in an unusually large range of risks/uncertainty around these forecasts.
• The inflation projection based upon the current level of market interest rates, as opposed to the more widely reported forecast that is prepared on the assumption of a constant base rate, could however prove to be the most informative. Expectations of the likely peak in the Bank of England’s tightening cycle - and in turn short-term, market determined interest rates - moved sharply higher in the aftermath of the January rate hike, with a move in the base rate towards the 5.75% to 6% area now priced-in. By showing how such an interest rate profile is seen to influence inflation over the forecast period (moving inflation above, below or towards the target level), the Inflation Report will provide some unofficial and indirect guidance on the ‘validity’ of this shift in rate expectations, creating scope for plenty of market volatility this week.
• The European Central Bank (ECB), meanwhile, appears to be following a more predictable script for the time being. Interest rates were left unchanged at last week’s meeting, but President Trichet’s commentary at the accompanying press conference supported expectations that a hike in March is still more likely than not. While the less hawkish tone of the ECB’s recent communications suggests that policymakers may have curbed some of their enthusiasm for rate hikes, this change of tack may simply reflect that – as interest rates return to more ‘normal’ levels – a series of further increases can no longer be signalled.
• However, some further tightening should still be expected, most likely at next month’s policy meeting, given the ECB’s continued reference to the currently accommodative policy stance, the excessive pace of monetary growth and the solid nature of the Euro-zone data releases. Indeed, after having cast a shadow over the region’s economy for well over a year, the initial evidence suggests that the impact of the German VAT hike has been relatively muted, removing a key risk around the economic outlook and a cause for caution on the ECB’s behalf. The Euro-zone service sector PMI - a useful lead indicator of overall GDP in the region – surprised on the upside in January and the broad range of indicators suggest that the ECB could easily ‘justify’ a further interest rate increase from current levels.

Key global market developments

• The fourth quarter US productivity data provided a welcome boost to the equity markets last week, rising by a stronger than expected 3% (annualised) pace and, by extension, producing a weaker rise in unit labour costs, up by just 1.7% (annualised) during the quarter following a 3.2% rise in Q3. The true level of ‘trend growth’ in the US has recently been the subject of much debate, given that the economy continued to absorb resources at a fairly rapid pace during the second half of the year (note the falling unemployment rate) even while headline growth (especially in Q3) was less than spectacular. Whilst last week’s figures will not remove these uncertainties entirely, the better news on unit labour costs - from both an inflation and profitability viewpoint - follows the general pattern of constructive data releases from the US economy during recent weeks.

Indices, Interest rates and Inflation

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