Europe Interest Rates: One Rise, One Hold

After assessments from the Bank of England and the European Central Bank, the key question is whether the May inflation report will lead to more tightening

by Natascha Gewaltig

European interest rates are on the rise. On May 10, the Bank of England hiked the policy rate by 25 basis points to 5.5%. The same day, the European Central Bank (ECB) left official interest rates unchanged, but hinted at another rate hike in June, and kept all options open for further moves in the second half of 2007.

The BoE's increase had been widely expected. Despite the rate hike, it maintained its risk assessment for inflation, with risks tilted to the upside over the medium term. Risks stem from the fact that the margin of spare capacity is limited and that businesses are better able to push through price increases.

Over the course of 2007, the bank expects consumer price index (CPI) inflation to slow to around 2%. (Previously, the near-term central projection had been for inflation to dip below the 2% target sometime this year, with risks skewed to the downside.) While consumer spending has been volatile, the underlying picture is for steady economic growth. All in all, the new projections are consistent with our expectations.

Britain: Retail Prices Jump

The key question for markets is now whether the May inflation report will signal more tightening in the second half or favor a more benign "wait and see" approach. On one hand, the BoE's letter to the Chancellor of the Exchequer—following the headline CPI breaking through 3.0% in March—allows the scope "to look through short-term volatility in inflation." With inflation now at 3.1% and inflation expectations in an uptrend, however, the bank's credibility seems to be at stake.

March inflation reached 3.1% year-over-year, up from 2.8% year-over-year in February—the highest level recorded since comparable records began in July, 1997. The retail price index (RPI) and the retail price index excluding mortgage interest payments (RPIX) rose to 4.8% and 3.9% year-over-year, respectively, reaching the highest rates recorded since July, 1991 (RPI), and September, 1992 (RPIX). The very strong retail price growth also increases the risk for higher wage growth, as many wage deals are based on these measures.

March inflation data serve as a stark reminder that although inflation is widely expected to slow in 2007, the pace of the slowdown is uncertain and upside risks still linger. However, there are dampening price effects as well, such as soft import price growth and rising labor supply. We assume that we have seen the peak in CPI inflation, which should allow the BoE to keep rates steady in Q3 and into Q4.

ECB Optimistic on Growth

Turning to the eurozone, the ECB did the expected and left official interest rates unchanged at the council meeting. The introductory statement was hawkish, however, and stressed that "strong vigilance" is of the essence, which in the past has signaled a rate hike in the following month.

The ECB remains relatively optimistic on the growth outlook, and said that growth remained solid and broad-based in Q1 and that looking ahead "the medium-term outlook for economic growth in the euro area continues to be favorable." External conditions are expected to provide support, while domestic demand is "expected to maintain its momentum." Investment should be supported by "favorable financing conditions, balance sheet restructuring, strong corporate earnings, and gains in business efficiency." Consumption is expected to strengthen "in line with developments in real disposable income," and is supported by "employment growth and improving labor market conditions."

The risks are still judged to be broadly balanced in the short term, but are seen skewed to the downside over a longer-term horizon. Risks stem mainly from external factors, and include "fears of a rise in protectionist pressures, the possibility of further increases in oil prices, and concerns about possible disorderly developments due to global imbalances." These comments are broadly unchanged from the last statement.