With the eurozone’s headline inflation running at 2.4% (y/y), the surprisingly hawkish comments from ECB President Trichet shocked the market by indicating that the ECB is likely to raise interest rates by 0.25% (from 1%) in April. UK inflation sits at 4.0% and will in all likelihood have increased beyond this point when the latest figure is released next week. However, in contrast to the ECB the BoE remains reluctant to raise interest rates, with the market pricing in a move by May at the very earliest. Both central banks have an inflation target of 2.0%, so what can explain this divergent approach?
Well, as the 0.6% GDP contraction in the final quarter of 2010 showed, the UK’s recovery is by no means guaranteed, with the dangers of stagflation and a double dip recession never far from focus. UK unemployment remains very high (nearly 8%) and the effects of the UK government’s austerity measures are yet to be truly felt by already tight household budgets. An interest rate hike is only likely to exacerbate these issues and the dovish majority within the MPC take the view that temporary factors are responsible for high UK inflation (such as VAT, oil prices and past sterling weakness). These factors are expected to fade over the longer to leave inflation on target. In truth, the UK’s recovery is on somewhat shakier ground than the eurozone’s (when taken as a whole) but the BoE risks losing credibility on tackling inflation.
The ECB’s more hawkish response is due to a stricter commitment to price stability, rather than the MPC’s approach of balancing this remit with stimulating economic growth. This can perhaps be put down to a more optimistic outlook from the ECB on eurozone and indeed global economic growth.
However, whether or not the ECB’s impending rate rise is prudent, remains to be seen. The move is not without its serious risks to ongoing eurozone periphery debt levels and bond yields - unemployment rates and budget deficits in states like Greece and Portugal vastly overshadow the UK’s. Much faith is being placed on German economic growth to drag the periphery out of recession but the rate rise could yet prove to be self-harming for the eurozone.
And finally, what implications does the ECB’s April rate rise have on the likelihood of a similarly early move from the BoE? That the ECB is convinced of the need to tighten monetary policy may persuade some of the more dovish MPC members to join Sentance’s growing hawkish faction (currently out-numbered by 6:3). However, the eurozone is the UK’s biggest export partner, and if an ECB rate hike slows demand for UK products then this could take much of the heat out of the British economy, which in itself could ease inflationary pressures
Fundamentally, the deciding factor for the MPC is likely to be the UK’s GDP performance in the first quarter of 2011 and if it does bounce back strongly, the MPC will find it difficult to resist tightening policy.
Richard Driver
Analyst – Caxton FX
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