Slowing euro area indicators will give ECB food for thought
Benign inflation and easing mortgage lending growth will weigh on rate levels
SENTIMENT on the future path of interest rates has taken a marked turn for the worse of late.
Traders now expect the ECB to raise rates to 4.5pc, a half point higher than the current level, with a similar increase also seen in the UK, which would take sterling interest rates up to 6pc.
The US is an exception in that rates are expected to remain unchanged there for the rest of the year, but again this represents a shift in mood, as a half point reduction had been expected just a few months ago.
This pessimism on the rate outlook is in some ways a puzzle because interest rates follow the economic cycle, and there is some evidence that the economic cycle has passed its peak.
If so, rates may not rise as the market expects, and we may indeed be at or very near the peak in this global interest rate cycle.
That cycle reached a previous peak in the year 2000, with US rates at 6.5pc and the eurozone equivalent at 4.75pc. The subsequent global downturn in 2001/2002 prompted central banks to ease monetary policy, culminating in rates of only 1pc in the US and 2pc in Europe.
The global economy picked up momentum again in 2003, and interest rates eventually followed; the Federal Reserve began to tighten policy in June 2004, followed belatedly by the ECB in late 2005, on concerns that rates were inappropriately low for the prevailing economic conditions.
Subsequent events have justified these central bank decisions, with global growth averaging around 5pc a year from 2004 to 2006, which is substantially above the 3.75pc average over the past 20 years. The US economy has slowed (the economy expanded by 1.9pc in the year to the first quarter of 2007) but the impact of this on the world economy has been broadly offset by a strong recovery in the euro area, led by Germany, and buoyant growth in Asia, notably in India and China.
Yet, we are now entering a very tricky period for central banks, and a dangerous one for economies.
Interest rates affect activity and inflation with a time-lag which can be up to a year or longer, so policy makers have to make a judgement call on that basis, which is why setting monetary policy is an art rather than a science.
There is always the risk of a policy error, be it stopping too soon and allowing inflation to become a problem or raising rates too aggressively and precipitating a sharp downturn.
The problem is exacerbated at turning points in the cycle, because these are often far clearer in retrospect than they are at the time - the Federal Reserve raised rates by 0.5pc, to 6.5pc, in May 2000, only to cut them by 1pc seven months later, and there was a similar time lag between the ECB's decision to move to 4.75pc and a quarter point cut in 2001.
The most recent data on the euro area highlights this point. Growth accelerated sharply in 2006, to 2.7pc, a six-year high, unemployment has fallen steadily, monetary growth is well above the ECB's target and business surveys point to solid economic sentiment.
This all suggests that the outlook is positive, which can be used to support the case for further rate increases. Yet, a closer look reveals that activity has passed peak momentum.
Annual GDP growth, for example, slowed to 3pc in the first quarter of 2007 from 3.3pc in the previous quarter, and survey indicators, although not weak, peaked last year and have decelerated since then.
Moreover, the rise in interest rates is now clearly having the desired effect on bank lending; household borrowing has slowed and the annual growth in mortgage lending in the euro area declined to 8.6pc in April from a high of over 12pc in 2006.
The economic growth experience also differs across the Continent, with annual growth in the first quarter varying from 3.6pc in Germany to 2.3pc in Italy and only 2pc in France.
It is also interesting to note the ECB itself expects euro area growth to slow in 2007 and 2008 which adds to the case for caution now on the interest rate cycle, particularly as the Bank also predicts that inflation will average 2pc in both years, and as such broadly in line with their target and past experience.
The ECB still sees upside risks to inflation, however, and views the current level of rates as being supportive of economic growth, which implies a bias towards further tightening.
That said, the Bank's rhetoric did change somewhat following the recent rate increase, and one suspects that any rate rises from here will be much more dependent on the flow of data.
On that basis, the next few months could be very significant in the rate cycle - any further deceleration in the growth of mortgage lending or further slippage in business sentiment may persuade the ECB that they have already done enough.
Dr Dan McLaughlin is
chief economist with
Bank of Ireland
