FYI | Jul 14 2008
By Chris Shaw
When the global credit crisis first hit a year ago the initial reaction from central banks was to loosen global monetary conditions as they pumped liquidity into the system to prevent financial markets from enduring even more chaos than was experienced.
This trend now appears to be drawing to a close however. Macquarie believes the unrelenting inflationary pressures being experienced in many economies around the world have set the stage for central banks to lift interest rates. Market participants are certainly factoring in such moves, as the broker notes futures markets in the US are forecasting US interest rates to climb to around 3.0% by 2010 from 2.0% at present.
While any hike in interest rates increases the possibility of corporate earnings growth declining from current levels and so sending equity markets lower, the broker takes the view any monetary action undertaken in the next year or so will likely be relatively modest.
Macquarie argues the central banks really have little choice in this regard as the economic growth outlook for the US remains weak and it appears the UK and European economies are set to weaken further. This should limit how aggressive policymakers can be with regards to lifting rates. As an example the broker is forecasting US growth to slow from around 2.0% this quarter to 1.7% in the December quarter and to 1.2% by the middle of next year. Similar slowdowns are predicted for both the EU and UK economies.
Assuming rates do go higher in the shorter-term this increases the risk of a global economic hard landing in the broker’s view. As an example the broker points out rising bond yields, as market participants factor in rate hikes, should put downward pressure on consumption and housing sector activity.
A rate hike would also further pressure the expected returns from equity markets, but as the broker notes the problem is if no action is taken in the short term it could spell even more trouble for equity markets later as policymakers may then be required to hike more aggressively if conditions worsen.
That said, there would be long-term gains from a modest increase in rates in the shorter-term in the broker’s view as such a move would dampen inflation expectations, which would then allow rates to remain at relatively low levels over the next few years. This in turn would be a positive for economic growth and equity market performance.
If rates go higher the US dollar is regarded as a likely beneficiary, while those economies with fixed exchange rates should also benefit as most use the greenback as the currency against which they set their own exchange rate level.
In historical terms rates are currently at very low levels, the broker pointing out real policy rates are currently negative not only in the US but in parts of Asia, the Middle East and Emerging Europe as well. As a result Macquarie suggests even if rates move higher in coming periods they will still not be at restrictive levels in the medium-term.
Looking specifically at a number of economies the broker takes the view the US remains at risk as there are some signs inflation may not follow the current downturn in the level of US economic growth, which would force the hand of the Federal Reserve and see them lift rates even as the economy remains weak. This is particularly a risk at present as higher commodity prices are flowing through into early signs of an increase in the Producer Price Index (PPI).
While the European Central Bank lifted rates by 0.25% earlier this month rates are not high given inflation is currently running at around 4.0%. With signs this elevated level of inflation may remain for some time the broker expects the trend in rates will remain up for a few years, though the pace of increases should be modest given concerns over the health of the financial system in general and some property markets in the region in particular.
Japan is currently experiencing headline inflation within its target range of 0-2.0% so it is among the least likely to be considering rate hikes in the broker’s view, especially as the Bank of Japan (BoJ) has expressed concern over the slowing economy. This is expected to take priority in terms of the BoJ’s policy settings, in the medium-term at least.
Elsewhere in Asia inflation remains above the target levels of central banks and so is a bigger issue. Macquarie notes the rise in inflationary expectations means policymakers have work to do in terms of bringing inflation back under control. Macquarie suggests at present Indonesia, India, Malaysia, the Philippines and Thailand are currently behind the curve, while Korea, Taiwan and Singapore appear to have the appropriate level of interest rates in place.
Policy in China is generally regarded as being tight but the broker questions whether this is really the case given rates have fallen behind inflation. Central bank rhetoric has highlighted how policy is tightening and in the broker’s view this approach is likely to work for China as households will put their money away and so allow domestic inflation to fall.
In Australia the broker suggests the Reserve Bank of Australia (RBA) is likely happy enough with its policy setting at present given demand is moderating and there are signs the tight labour market is now easing, though further tightening is likely from commercial banks lifting their lending rates.
While the RBA is not expected to move again on rates this year its tightening bias should remain in the broker’s view, though action is expected if spending again spikes higher on the back of tax cuts and improvements in the terms of trade. Rates are unlikely to move lower until well into 2009 on the broker’s forecasts.
New Zealand in contrast is expected to be one of the few central banks to cut interest rates over the next year or so, as even with inflation above comfort levels there are signs the economy is heading into a recession given the downturn in the housing market and a drought affecting activity levels generally.
Also supportive of future rate cuts is the fact that the level of interest rates is already very restrictive at 8.25%, while a strong exchange rate is also not helping currently. Given its place as a major currency of interest with respect to the carry trade the broker suggests any lowering of rates in New Zealand could see its dollar fall heavily, which in turn should see gains in exports and so produce a more sustainable economy than the one of the last few years, which has been moving along primarily on the back of a strong housing market and increased debt levels.
