Preview of Bank of England and ECB Rate Decisions

August 6, 2008

On Thursday at 11:00 GMT, I’m confident that the Bank of England will announce an unchanged 5.0% bank rate and even more certain that the ECB will follow suit by keeping its 4.0% refinancing rate 45 minutes later.  The Bank of England does not release a statement immediately when it fails to change policy.  Minutes of the meeting get published in mid-August.  The U.K. Bank Rate has been at 5.0% since a 25-basis point cut in April.  Blanchflower has dissented in favor of a more stimulative policy course at nine of the last ten meetings but converted Gieve (only in March) and nobody else at that or any of the other eight meetings to his side.  The U.K. economy is slowing faster than expected as Blanchflower predicted it would.  Housing prices are down sharply and have a good potential to drop in total by more than U.S. real estate values.  The U.K. factory PMI index fell to 44.3 in July, lowest since 12/98, and industrial output fell by 1.1% in the year to 2Q08.  The service sector is contracting, too, with sub-50 PMI scores of 47.1 in June and 47.4 in July. Retail sales are imploding.  Britain used to be lumped together with Australia and New Zealand.  All three economies had relatively elevated high-water marks in their central bank rates: 8.25% in New Zealand, 7.25% in Australia and 5.75% in Britain.  The heavy dose of central bank restraint combined with other headwinds to abruptly throttle growth back sharply in each case.  Central banks in New Zealand and Australia each shifted their policy bias to ease before inflation had crested, and New Zealand followed that with a rate cut and the promise of many more cuts.  The Bank of England implemented rate cuts in December, February and April when officials were expecting less future inflation than they now are forecasting.  It is possible that the Monetary Policy Committee will this week lay the groundwork for resumed rate cuts in 2008.  In any case, they will downgrade their assessment of growth in the quarterly inflation report that arrives later this month.  The minutes of this week’s meeting will be used either to prepare markets for further rate cuts in 2008 or to quell speculation about such a possibility.  It’s a tough call for forecasters and an ever tougher one fraught with second-guessing for the policymakers.  I think they will open the possibility of easing later but leave sufficient ambiguity in their language to allow themselves leeway to abort such a plan.  Besley probably will dissent in favor of a rate increase again as he did in July.

The ECB doesn’t release new growth and inflation forecasts until September but will probably qualitatively acknowledge that activity prospects are developing more weakly than they assumed before.  Consumer confidence and business sentiment are both sinking rapidly.  The region’s PMI’s are each below 50, signaling contraction.  They are lower than their U.S. counterparts, and the gap between the U.S. and Euroland PMI scores is widening.  Retail sales declined 3.1% in the second quarter at an annualized rate.  It is doubtful, however, that ECB officials will concede the point made, for example, by Australian monetary officials that weaker growth inevitably will take care of restoring price stability.  One cannot count on oil prices staying down, and such would have to fall substantially further to remove the threat of higher inflation.  Indeed, oil prices are still up more than 60% from year-ago levels and compared to the average level in 2007.  In the meantime, evidence of incipient second-order inflation persists.  Producer prices leaped 11.2% at an annualized rate between 1Q and 2Q08, and non-energy PPI inflation reached 4.0% y/y in June.  I expect a more dovish statement than in July, when the ECB raised rates by 25 basis points, but a more hawkish tone than euro bears are assuming and hoping.  A comparison of the FOMC statement on Tuesday and the ECB statement on Thursday will offer little hope for significant convergence of short-term interest rates.  The 3-month eurodollar/euribor spread has averaged -213 basis points since end-March and is presently 217 basis points wide.  This differential in 2007 averaged +102 basis points with U.S. rates on top, by comparison.

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