Markets & Finance

Europe's Two Big Central Banks Raise Rates


Are Europe's central bankers seeing a greater threat from inflation than the markets previously thought? Apparently so. In a surprise move, Bank of England officials hiked the benchmark British interest rate by 25 basis points on Aug. 3, while the BoE's Continental counterpart, the European Central Bank, tightened by a similar amount, as had been widely expected. The moves bring the BoE's key policy rate to 4.75%, while the ECB's refi rate rises to 3.0%.

Both major European central banks have problems with inflation, which is no surprise considering that such pressures, to a large extent, stem from energy price rises. However it is worth pointing out that the Aug. 3 rate hikes appeared totally independent of each other, and more of a coincidence than an indication that BoE and ECB will be moving in sync from now on.

Currency markets reacted swiftly to the two hikes, with the euro and pound sterling rallying solidly. The dollar was sharply lower against both—not surprisingly, given that the Federal Reserve appears to be on the opposite policy trajectory.

PREEMPTIVE MOVE. In a statement issued after its policy meeting, the BoE pointed to the ongoing strength in the British economy, noting that household spending had recovered while business investment had picked up and exports remained robust. It went on to say that the degree of spare capacity in the British economy appears small.

Clearly, inflation concerns are rising. The BoE's unexpected hike was meant as a shot across the bow of financial markets, as officials hope to preempt inflation expectations given that price growth is now "likely to remain above target for some while." That's in contrast to an earlier statement from BoE officials to the effect that they will not hesitate to change interest rates to keep inflation on track.

The question is whether more rate hikes are in store before yearend. Money markets give 40% odds on another move by the BoE before yearend, and we at Action Economics think this is a fair assessment of the likelihood.

STILL ACCOMMODATING. The ECB's hike was more widely expected, as council members had offered heavy hints on such a move since its last meeting on July 5. At a press conference held after the rate decision, ECB President Jean-Claude Trichet said the Aug. 3 decision reflects upside risks to price stability, and will help to anchor inflation expectations. All in all, the ECB expects inflation to remain above 2% this year and next, with the risks to the upside.

Trichet said ECB rates remain low and liquidity ample, so monetary policy remains "accommodative." But the central bank may find it necessary to drain the punch bowl further. Trichet said "progressive withdrawal of accommodation will be warranted" if developments on inflation are in line with expectations, and that the ECB will "continue to monitor closely all developments."

The ECB's choice of language here is crucial to the outlook, confirming Action Economics' view that the bank will continue to hike rates in the future—but not right away. The fact that Trichet only said the ECB will "monitor developments closely" and did not mention the word "vigilance"—a term emphasized after the last policy meeting—would point to stable rates at the next meeting in late August. Indeed, in a Q&A session following the meeting, Trichet said the bank is not committed to future hikes or to any pattern in interest rate increases.

ALL CONNECTED. As for growth in the euro zone, the ECB noted downside risks in the medium- to long-term due to oil prices, imbalances, and protectionism. The bank noted high money-supply growth and strong credit growth. Trichet admits that recent geopolitical events pose a risk to growth, but also said that he does not see a materialization of these risks so far.

While the ECB and BoE have set their sights on price stability this time around, they and their central bank peers in Washington, Tokyo, and Beijing are treading a treacherous path, given the interdependence that is the hallmark of the global economy.

To wit: If one central bank overshoots on monetary tightenings, any big slowing in growth in that region may weigh heavily on other economies as well. But if policymakers fail to hike rates sufficiently to contain inflation, an entirely different set of problems may be unleashed around the globe.


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