the jury is out on further UK rises, while ecb continues to increase rates and US stays steady
While policymakers raised interest rates in the UK and the eurozone in August, the US Federal Reserve stayed its hand for the first time in two years.
The Bank of England's Monetary Policy Committee (MPC) raised UK interest rates by a quarter-point at its August meeting to 4.75% and investors remain convinced there is more to come, pricing in at least one more rate hike by the end of the year.
However, some are arguing against this, suggesting the August decision actually reduces the likelihood of further rises (the stitch-in-time argument).
Additionally, the elevated level of sterling will bear down on UK output and inflation (as UK exports become less competitive in international markets, while the prices paid for imports falls). The MPC's Catch-22 is if expectations of further rate hikes subside, sterling is likely to fall.
All told, the course of monetary policy is as difficult to predict as it has been for some time. The MPC's August Inflation Report left the door wide open to further tightening, if the data warranted it.
The US Federal Reserve left interest rates on hold at 5.25% at its August meeting, interrupting the long run of monetary tightening that began in June 2004. Although inflation is currently above the preferred range, policymakers expect it to come down now the economy is slowing.
The Fed is confident the 17 rate hikes previously implemented will ensure economic growth does not rebound above its trend rate in the quarters ahead (it takes 18 months for a rate hike to have its full effect on the economy).
This may be wishful thinking. Recent data releases suggest growth in quarter two was stronger than first thought (probably above 3% rather than the 2.5% initially reported). Moreover, at 5.25% rates are barely above neutral (where they are neither restricting nor stimulating activity).
As a result, previous rate hikes may not have as strong a restraining effect on the economy as many anticipate, especially since the impact of higher short-term rates has been partly offset by a decline in long-term interest rates and a weaker exchange rate.
One more rate hike to 5.5% will probably be necessary before the end of 2006 to ensure the economy slows back to its trend rate and price pressures remain contained.
The European Central Bank (ECB) raised interest rates by another quarter-point, to 3%, at the beginning of August. This was the fourth such increase since December 2005 and represents an acceleration in the pace of policy tightening to every two months rather than every three months.
ECB president Jean-Claude Trichet had virtually pre-announced a rate increase by using the phrase "strong vigilance" with regards to inflation risks a number of times at the July press conference - normally a sign that a rate increase is imminent.
At the August press conference, Trichet continued to describe policy as "accommodative". He also said: "If our assumptions and baseline scenario are confirmed, a progressive withdrawal of monetary accommodation will be warranted". In other words, rates have further to rise.
It is likely short-term interest rates in the eurozone will end the year at 3.5%, with 25 basis point increases at the October and December meetings.
One further rate increase is likely in early 2007, bringing interest rates to 3.75%, providing the eurozone economic recovery continues into next year, as expected.
There are plenty of grounds for optimism on that front - data released since the ECB's August meeting show the eurozone economy expanded at its fastest rate for six years in quarter two.
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