Tuesday, March 6, 2007

Central Bank Watch

Both the ECB and Bank of England meet this Thursday and the outcome will have a major impact on the direction of each currency over the next month or so. The ECB will be raising rates to 3.75% but the key question is what will happen to rates thereafter. The market is expecting at least one more rate hike, probably in June, but in view of recent economic data and the uncertainty surrounding the prospects for the global economy going forward, a further rate hike is by no means assured. If the ECB President – Jean Claude Trichet, is perceived as being dovish in any way on Thursday, then the euro could face a backlash and we could see EUR/USD retreat to below 1.30 again. With euro zone inflation currently standing at a mere 1.8% combined with scares about the direction of the US economy and the euro economy itself showing signs of having peaked, Trichet may find himself unable to be as hawkish as he has done at recent meetings. While he is sure to refer to the upside risks to inflation of changes in energy costs, those seeking some concrete referral or coded signal, for a further impending rate hike, may well be disappointed. It will also be very interesting to see how Trichet responds to questions as to the ‘cause’ of the recent sharp reversal in global financial markets, a question he is sure to be asked.

The Bank of England has become something of an enigma in recent months and one never quite knows what to expect from them. Given their appetite for delivering the unexpected, a further surprise rate hike this week is not beyond the bounds of possibility. Production output, bank lending and house prices have been very robust in the past month and if February’s inflation data sees UK consumer prices on the rise again, then the Monetary Policy Committee may feel justified in acting now, rather than wait. Against that, UK retail consumption slumped in January and the country’s key services sector slowed in February. Fears over excessive inflationary earnings awards in the recent wage round have largely abated. Some Committee members are likely to opt for an increase this month, given that a minority two members voted for a rise at the last meeting. Unless consumer prices have risen unexpectedly again in February, it seems likely that the Committee will opt to keep rates on pat, allowing more time for recent rate increases to bed into the economy and to take a stranglehold on prices. The market certainly doesn’t expect a rate increase this week and if the Bank were to surprise yet again, then given the turmoil in financial markets over the past week, it may well prove to be this Committee’s least popular and boldest move to date. The Bank’s recent Inflation Report stated a requirement for a further rate increase in the second quarter, to bring inflation to within the target rate by the end of the year. We are not yet in the second quarter, but then again this is the Bank of England we are talking about.