European interest rates on the rise - British and European central banks stick to the script

European interest rates on the rise
By Chris Giles in London and Ralph Atkins in Frankfurt
Copyright The Financial Times Limited 2007
Published: July 5 2007 19:47 | Last updated: July 5 2007 19:47


European interest rates were on the rise yesterday after the Bank of England announced another increase in borrowing costs and the European Central Bank signalled that eurozone rates were likely to go up in September.

The Bank of England did nothing to confound market expectations of 6 per cent rates before the end of the year as it raised its main interest rate for the fifth time in a year to 5.75 per cent. It cited strong growth, limited spare capacity and indications businesses were poised to raise prices for the rise.

The ECB fears capacity constraints will push up inflation in the 13-member eurozone. Jean-Claude Trichet, the ECB president, also highlighted dangers posed by “vigorous monetary and credit growth in an environment of already ample liquidity”.

The similarity in the European central banks’ thinking was striking. While uncertain about the direction of inflation, they warned that rapid economic growth and limited spare capacity had heightened risks and demanded some action.

Economists and investors suggested the Bank of England would soon raise interest rates again to 6 per cent, a rate not exceeded since 1998. A Reuters poll showed that just over half of the 57 economists surveyed expected UK rates to hit this level by the end of the year.

The Bank of England’s statement gave no hints about future rises but stressed that although inflation would fall this year as gas and electricity prices fell, “most indicators of pricing pressure remain elevated”.

“The balance of risks to the outlook for inflation in the medium term continued to lie to the upside,” it added as it said that these risks had persuaded the majority on the nine-member monetary policy committee to vote for higher rates.

Andrew Smith, chief economist of KPMG, the accountants, said the MPC would relax only when growth slows. “This could well happen of its own accord as past rate increases bite – but if not, it is too early to call the peak of the rate cycle”.

Since December 2005, the ECB has lifted its main rate eight times to 4 per cent. No change was announced yesterday but Mr Trichet said he would not want to change market expectations on the timing of the next move. Markets had seen a two-thirds chance of a September rise, with October a less likely possibility.

A September rise would raise the possibility of a further increase this year – likely to be seen by many ECB governing council members as justified given strong data on eurozone activity. “I don’t see why they would slow down the pace right now,” said Erik Nielsen, economist at Goldman Sachs.

The ECB’s governing council will meet by teleconference in August, when much of Europe is on holiday, but Mr Trichet made clear that he could still brief the media soon afterwards.

British and European central banks stick to the script
Copyright The Financial Times Limited 2007
Published: July 5 2007 21:47 | Last updated: July 5 2007 21:47


The Bank of England’s rate rise on Thursday – a quarter of a percentage point to a six-year high of 5.75 per cent – may have been predictable, but it will give consumers pause for thought. The European Central Bank meanwhile kept rates steady at 4 per cent, but signalled that markets can expect a rise later this year. Despite some doubts over the future direction of UK and European inflation, the decisions were correct, albeit a month too late in the case of the BoE.

The UK rise came four weeks after Mervyn King, the governor, was outvoted 5-4 in the Bank’s decision to keep rates steady despite signs of persistent inflationary pressures. Back then, some voting with the majority were concerned about surprising markets. That clearly was not a problem on Thursday.

The signs that were apparent last month still exist today: growth is strong in the UK and most parts of the world, consumer spending remains high, and there are still ample supplies of money and credit. Add to that high oil prices and strong equity markets and you have a formula for an inflationary threat.

But alongside these pointers, there are two substantial British economic uncertainties on the horizon: first, even with strong domestic growth, the UK labour market looks surprisingly weak. Neither wages nor employment have kept pace with output growth. Yet business surveys point to companies itching to raise prices in the near future.

Second, the path of UK consumer spending could slow in the autumn as many homeowners are coming off fixed mortgages. Low interest rates in the back half of 2005 encouraged many consumers to take out new loans, many of them with guaranteed rates set for two years. As interest rates adjust upwards by as much as 1 to 1.5 percentage points, consumers might cut their spending in other areas. This holds particularly true with an already low savings rate and consumers borrowing against their homes to foot their bills.

Both factors mean that consumption could turn quickly in the months ahead and make future inflation and rate decisions less certain. If UK labour markets remain weak and increased mortgage rates have adverse effects on spending, the Bank may not want to raise rates to 6 per cent before the end of the year, as many expect.

But none of this should have prevented action. Self-sustaining growth – with no contagion from the sluggish US economy – calls for higher interest rates. The BoE has done its part. The ECB might follow suit when it gets its next chance.




Reasons to raise rates still further, and reasons not to
By Ralph Atkins in Frankfurt
Copyright The Financial Times Limited 2007
Published: July 6 2007 03:00 | Last updated: July 6 2007 03:00


With signs of an underlying improvement in the eurozone's economic performance, politicians may hope the European Central Bank will hold back from further interest rate increases in its battle against inflation.

At first sight it may seem obvious that if structural improvements have reduced immediate threats to price stability, the need to curb the economy is less urgent.
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Alan Greenspan, when US Federal Reserve chairman, famously spotted a technology-driven trend rise in US productivity growth in the 1990s that would contain inflation. A recent improvement in eurozone productivity may prove lasting.

But even if eurozone "potential growth" - the pace at which the economy can expand without creating excessive inflation - has risen, there are differences of opinion at the ECB on the implications for borrowing costs. While some might see a case for caution in increasing interest rates, others would argue the opposite: that the US experience illustrates the dangers of keeping interest rates low in a rapidly expanding economy.

If investors see a region's growth prospects brightening they might increase investment, driving up asset prices and demand, thus creating inflationary pressures over the longer term. Delaying interest rate rises could lead to excessive investment and a credit boom, sowing the seeds of future instability, says Julian Callow, economist at Barclays Capital.

"It is quite a dangerous game for central bankers to play. It might seem the right thing to do in the short term but prove wrong in the longer term," he said.

For the ECB, fast-growing eurozone money and credit data are already flashing alarm signals. Lending to businesses, for instance, is increasing at near-record rates, reflecting merger and acquisition activity, including by private equity groups.

The central bank's other big fear is that fast growth is leading to higher wage settlements - concerns that will have been exacerbated by this week's rail strikes in Germany over pay demands of 7 per cent and more.

Moreover, if the ECB did raise its estimate of eurozone potential growth, currently about 2.25 per cent, it would probably be by a quarter point at most. Given the uncertainties surrounding such estimates, that is unlikely to lead to dramatic changes in ECB thinking.