Global Markets Weekly – 14^th May 2007

Key Macro economic developments

• As had been universally expected, the Bank of England last week pushed interest rates up once more by a quarter of a percentage point to 5.5%, the highest level for some six years. Furthermore, it still has a clear bias towards additional tightening, judging by the accompanying statement from the Monetary Policy Committee (MPC). The rapid pace of monetary growth, robust international outlook and limited degree of spare capacity within the UK economy were highlighted, and all these themes are likely to feature prominently in the Bank’s May Inflation Report, due for release this week (Wednesday).
• Yet the extent to which such posturing will result in further rate hikes remains to be seen. We still believe that, with the housing market displaying signs of a slowdown and with a fair degree of monetary tightening already in the pipeline, 5.5% will prove to be the peak in the cycle. Policy-makers probably also hope that the current profile of market interest rates – having risen to an elevated level on speculation of further rate hikes – will be doing some of the job for them, mitigating the need for official action.
• But, with inflation more than a percentage point above the target rate, the MPC are going to talk tough in the near term, mindful of safeguarding their credibility. Much will depend on whether the various members of the MPC think there is enough breathing space to allow a period of contemplation and review, or whether they see the need for further action in the short term, even if any additional rate hikes from here are swiftly reversed. With this in mind, measures of inflation expectations and corporate pricing power will be well worth watching. The short-term path of current inflation (though obviously beyond the control of policy-makers) could also prove crucial, and a swift move below 3% – starting with Tuesday’s release of the CPI data for April – would take some of the pressure off the MPC.
• Meanwhile, the European Central Bank continues to operate monetary policy by codeword approach, with President Trichet’s utterance of the ‘strong vigilance’ term last week teeing up the financial markets for a June rate hike. Such a move has been expected for some time, and the ebb and flow of the various data releases have done little to challenge the view that interest rates in the euro-zone are still at a slightly expansionary level. Monetary growth, for instance, continues to advance at a rate that will trouble policy-makers, even if signs of a slowdown have begun to emerge in the French and Spanish housing markets.
• In the US, the Federal Reserve (Fed) continues to juggle the contrasting influences on policy from the housing-led slowdown and stubbornly high inflationary pressures. The latter appear to be winning out at present, but the Fed has given precious few hints of any imminent change in policy, and it would probably take a major shift in the trajectory of the data – in either direction – before any movement becomes a possibility.

Key global market developments

• With sentiment towards global growth currently at a healthy level, it seems that any nasty surprises on the data are more likely to come from an inflation perspective. Central banks dominated the economic agenda last week, and the threat of higher interest rates will doubtless be a feature of the summer. But are the financial markets truly concerned by a possible re-emergence of inflation? Judging by the break-even inflation rates embedded within the various government bond markets, the answer appears to be ‘not yet’. The current implied inflation rates are only around the average levels of recent months. Depending on your outlook, this may be seen as either a positive (that faith in central banks remains) or a negative (that financial markets are complacent about this threat).

Indices, Interest rates and Inflation

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