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Big three central banks tone down rate rise threats
06.17.08, 4:45 PM ET
By Mike Dolan and Ros Krasny
LONDON (Reuters) - The world's three biggest central banks Tuesday directly or indirectly tamped down expectations for aggressive interest rate rises to counter rising inflation, sending bond yields tumbling in relief.
Debt markets have spent the past two weeks being buffeted by hawkish central banker rhetoric, but moderation and a call for patience was the order of the day from the U.S. Federal Reserve, European Central Bank, and Bank of England.
Economists said the shift underlined the policy dilemma facing central banks as they cope with conflicting signals from rising inflation and slowing economic growth.
The first salvo came from stories in the Financial Times and Wall Street Journal suggesting that the U.S. central bank was unlikely to raise interest rates in the next few months unless the inflation outlook worsens, and that Fed officials feel the market has overplayed its hand.
"The impression given is that the swing in market rate expectations may now have gone too far," said Ken Wattret, economist at BNP Paribas (other-otc: BNPQY.PK - news - people ) in London.
A sense that the Fed has some time up its sleeve in the fight against inflation was backed up by Tuesday's reports on U.S. wholesale prices, housing starts, and industrial output.
The core producer price index for May rose by an as-expected 0.2 percent, for a year-on-year increase of 3.0 percent, a far cry from the startling 7.2-percent jump in year-over-year producer prices overall.
"There is price restraint in the core, even at the wholesale level," said Chris Low, chief economist at FTN Financial in New York. "The challenge for policy makers is to ensure that consumers are forced to continue making the hard budgeting decisions that force discretionary goods prices down."
Financial markets slapped down the implied chances for a Fed rate rise in August, from a near-certain 90 percent on Monday to an ambivalent 52 percent. The Fed's benchmark rate was cut to 2.0 percent in May.
Longer-dated U.S. Treasury yields also fell sharply and the U.S. dollar weakened as dealers reassessed the Fed policy landscape.
Global stocks were mostly higher, but U.S. equities tumbled after a warning by investment bank Goldman Sachs (nyse: GS - news - people ) hinting at further fallout from the long-running mortgage crisis.
EUROPEAN DOVES WEIGH IN
To the surprise of many dealers, senior European Central Bank officials delivered similarly dovish comments on the outlook for their interest rates, a marked departure from several weeks of hawkish rhetoric.
Executive Board member Lorenzo Bini Smaghi led the way, saying that a lone quarter percentage point rise in the ECB's key interest rate should be enough to bring euro zone inflation back below 2.0 percent.
"In our view such a tightening, which I would call significant even if (it is) just 25 basis points, should be able to bring inflation back below the 2.0 percent target in the next 18 to 24 months," Bini Smaghi said in an interview with Italian daily Il Sole 24 Ore.
After shocking European interest rate markets earlier this month with a warning of a rise in its key policy rate in July, financial markets had moved to price a quarter-point rise to 4.25 percent next month and another later in the year.
Bini Smaghi's comments, however, triggered a decline in European government bond yields <FGBLc1> and expected short-term interest rates by year end <FEIZ8>.
ECB Governing Council member Yves Mersch later noted a "possible certainty" of a rate rise at the ECB's July 3 meeting, but also counseled patience.
"It will only be over the medium-term that we see inflation come back to levels that are in line with our definition of price stability," Mersch said at the Luxembourg central bank's annual report presentation.
The ECB is "looking through the peak in inflation, but every time they look the peak is a little bit higher," said Geoffrey Dicks, economist at RBS in London. "So far at least, they seem to be living with this level of discomfort without acting."
BOE'S OVERSHOOT
Rate rise expectations were also dampened by the Bank of England, even after after a report of UK inflation rising to 3.3 percent in May, above forecasts and more than a percentage point above the bank's 2.0 percent inflation target.
In a letter to the government explaining the overshoot, the UK central bank said that while inflation could yet spike above 4.0 percent this year on soaring food and fuel bills, the focus was on bringing inflation back to the 2.0 percent target in two years' time.
The bank's Monetary Policy Committee believes that if key rates were set at levels high enough to drag inflation back to target within just a year, "the result would be unnecessary volatility in output and employment," wrote BoE governor Mervyn King.
"The risk is that the slowdown could be so sharp that inflation did not just return to the target but was pulled below," King wrote.
Money markets, which had been betting on as many as three Bank of England rate rises from the current 5.0 percent, moved swiftly to price in a lower rate trajectory on sterling interest rates <0#FSS:>.
"The BoE believes that inflation will peak later this year and then fall back towards target, and they seem at pains to suggest that an aggressive series of rate hikes, as currently priced in by markets, is unlikely," said James Knightly, economist at ING (nyse: IND - news - people ) in London.
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