It was a busy week for central bank meetings last week:
The Reserve Bank of Australia left its cash rate unchanged at 4.75%. That’s largely due to the RBA conceding their expectations for economic growth this year are too high. They are forecasting 4.25% growth this compared with the Treasury’s pick of 4%. Both are probably too high in our view. Household spending has been more subdued than expected and risks to global economic growth have re-emerged. While growth may well prove to be lower than expected this year, potential growth is most likely also lower than previously. That means excess capacity may not be as large as some expect. We believe interest rates will move higher in Australia this year, but the strong exchange rate is buying the RBA time.
The People’s Bank of China raised rates interest rates again with the one-year Yuan lending rate raised 25bps to 6.56% and the one-year deposit rate raised to 3.5%. This was against our expectation. We believe that while inflation in China increased again in June, it is close to peaking. Furthermore, there are clear signs the Chinese economy is slowing. Further interest rate increases from here risk losing the necessary balance between controlling inflation and avoiding a hard landing. Our preference is for a faster appreciation in the exchange rate which has the added benefit of supporting the necessary rebalancing of the economy. Exchange rate appreciation shifts some of the burden to the export sector while at the same time delivering a boost to real household incomes as imports become cheaper.
The European Central Bank raised rates a second time with the benchmark interest rate being raised 25bps to 1.5%. As we said at the time of the first rate hike in April, we believe the ECB has embarked on a risky strategy. While it is certainly the case that growth in some parts of Europe (Germany, France) warrants somewhat less accommodative monetary policy, other parts (Greece, Portugal) are struggling under the weight of increasingly austere fiscal policy and recession. In these latter countries the competitiveness boost from a weaker exchange rate is about the only growth respite as domestic demand contracts. Interestingly, at the time of the announcement on interest rates, ECB President Jean-Claude Trichet conceded the global and European growth outlook had deteriorated in recent weeks. It appears likely, however, that the ECB will continue on this gradual tightening path. But don’t expect another tightening until September.
The Bank of England left its benchmark rate at 0.5%. Again, in a theme that was common in most central bank meetings this week, the weaker global growth outlook was discussed. The Monetary Policy Committee conceded “the current weakness of demand growth was likely to persist for longer than previously thought.” The minutes of the meeting suggest there is some support for extending the £200 billion Gilt quantitative easing program. It should not be ignored that the UK is embarking on one of the most aggressive fiscal consolidation programs in the OECD. This means monetary policy can remain more accommodative for longer. While tighter fiscal policy will impact negatively on domestic demand, there are more positive signs on business investment and exports. While that remains the case we don’t believe we will see further QE in the UK. But as with the US, we don’t expect any tightening in conditions until well into 2012.