Central Bank Watch: Bernanke Warns of U.S. Contraction, RBA Holds Rate

The main highlights of the week so far in central bank-related news included Fed Chairman Ben Bernanke�s testimony on the U.S. economy and financial markets on Wednesday, along with the Reserve Bank of Australia�s decision to hold rates at 7.25%. There were also some central bank speakers, including the Bank of Canada�s deputy governor Paul Jenkins, who spoke on Wednesday.

U.S. Federal Reserve

Current Rate: 2.25%
Next Rate Decision: April 30
Expectation: 12% chance of 50 bps cut, 100% chance of 25% cut

Federal Reserve Chairman Ben Bernanke touched on a variety of factors contributing to the current weak state of the U.S. economy, saying it may contract in the first half of the year, while testifying before the congressional Joint Economic Committee.

He also defended the Fed's recent actions to facilitate a deal that prevented a major investment bank from collapsing. Bernanke said the Bear Stearns deal was not a bailout and that it would normally not have been a matter for Fed involvement except that the company was widely interconnected to many areas of "critical" markets. He also said there were no early warning signs on the Bear Stearns liquidity troubles. And that he doesn�t expect a repeat of the Bear Stearns situation.

In questioning following his prepared statement, Bernanke said the U.S. is experiencing small economic growth and that a recession is possible. In light of the modern market, Bernanke said it�s time to think about reforms to the regulatory system, though said he had no plans for additional tools. He also said wage inequality had risen in the U.S. and that it needs to be addressed.

Earlier in the week, San Francisco Fed Bank President Janet Yellen said more work needs to be done to mitigate the growing mortgage foreclosure crisis, saying steps taken to date at the federal level and by lenders are not enough. Risks associated with changes in consumer credit marketsm were "greatly underestimated," she said, adding that the U.S. economy and markets are "now grappling with the consequences."

Bernanke will testify again on Thursday before the Senate Banking Committee's hearing on the Fed's involvement in the JPMorgan, Bear Stearns deal.

Bank of Canada

Current Rate: 3.50%
Next Rate Decision: April 22
Expectation: Markets pricing in 76% of a 50 bps cut

Bank of Canada Deputy Governor Paul Jenkins reiterated comments that further monetary stimulus will likely be needed in the near term to achieve the 2% inflation target over the medium term. In a speech to the London, Ont. chamber of commerce on Wednesday, Jenkins said the most immediate challenge facing the global economy and Canada is the U.S. slowdown, adding that global trade imbalances must be addressed. He also said the U.S. subprime mortgage problems and the associated re-pricing of risk are �by no means fully played out.�

Jenkins said heightened commodity prices are generating a substantial boost to incomes in Canada, leading to an increase in domestic demand which is offsetting weakness in the export sector.

Looking ahead, investors will be paying close attention to remarks by BoC Deputy Governor David Longworth on Wednesday next week and Governor Carney's appearance at the G7 meeting on April 11th.

Reserve Bank of Australia

Current Rate: 7.25%
Next Rate Decision: May 6
Expectation: Hold, with 4% chance of a 25 bps hike

Earlier in the week, the Reserve Bank of Australia held its key lending rate at 7.25%, as many economists had expected. Economists say the accompanying statement, which said the current monetary policy setting is �appropriate for the time being� signals the bank may be ending its five-year hiking cycle.

"(The) short statement suggests that the RBA is in wait-and-watch mode as it assesses whether the 'substantial' tightening in overall financial conditions since the middle of last year is enough to generate the significant and sustained slowdown needed to see inflation move back into the target range," said RBC analyst Su-Lin Ong.

European Central Bank

Current Rate: 4.00%
Next Rate Decision: April 10
Expectation: Hold, with 14% chance of a 25 bps cut

There were several ECB speakers this week, including Bank of France Governor Christian Noyer who said the financial crisis is not yet over, but that the outlook for Europe remains optimistic and that he does not expect a recession in the euro zone. Despite prospects of a possible economic slowdown in the region, Noyer said the logic behind rate cuts in the United States did not translate into the European economic situation, pointing out that liquidity injections were not the same thing as monetary policy.

Speaking in an interview with Finnish television MTV3, Finnish Central Bank Governor Erkki Liikanen said risks to euro zone price stability remain on the upside with growth risks on the downside. However, he pointed out that the European Central Bank's primary mandate is controlling inflation, and the current 4.00% rate would help in that mission. "We decided in March that the benchmark rate will be 4% and that decisions stands," he said.

On Monday, Bank of Spain Governor Miguel �ngel Fern�ndez Ord��ez said economic growth and inflation posed a dilemma for monetary policy-makers, emphasizing that short-term inflation pressures have been seen and that there was a high level of uncertainty regarding euro zone economic growth. However, the Spanish central banker also noted that the euro zone economic fundamentals were sound and that inflation could slow towards 2% by the second half of 2008.

Bank of Japan

Current Rate: 0.50%
Next Rate Decision: April 9
Expectation: Hold

The major release in Japan this week was the Bank of Japan�s first quarter Tankan report, which showed confidence amongst the country�s business leaders sunk more than expected to a four-year low. The headline large manufacturers index fell to 11 in the first quarter from a previous reading of 19 and below the consensus forecast of 13. The report noted the figure is expected to deteriorate further to +7 in June.

The outlook amongst large manufacturers was equally downbeat in the report, coming in at a reading of 7, below the 9 economists had expected. The all-industries Capex index, which measures capital expenditures by all Japanese industries except for the financial sector, showed large manufacturers and non-manufacturers plan to decrease business investment by 1.6% in fiscal 2008.

Economists at Barclays Capital said the first quarter Tankan results point to a soft Japanese economy and expect the Bank of Japan to remain on hold in the near term, but forecast a 25 bps hike in Q4.

But Julian Jessop, Chief International Economist at Capital Economics, noted �An increasing number of forecasters are predicting that the next move in Japanese rates will be a cut, although speculation appears to be focusing on June or sometime in the third quarter rather than this month.� Markets are currently pricing in a 7% chance of a 25 bps cut next week, but as much as a 46% chance of a cut by mid-September.

Jessop said further easing could �seem like a panic� or may appear as confirmation that Japan�s economy is as sick as it was in 2001. �The longer that rates are left on hold, the more likely that global economic and market conditions will be recovering sufficiently for the next move to be another hike,� he said.�It is unlikely that any new Governor, particularly a stand-in, would want to change policy at his first meeting in charge.

Bank of England

Current Rate: 5.25%
Next Rate Decision: April 10
Expectation: Markets pricing in 53% chance of a 25 bps cut

Bank of England Governor Mervyn King said on Monday that even though a correction in the UK economy was necessary to some extent for tempering inflation expectations, the central bank�s Monetary Policy Committee cannot allow the UK economy to slow too sharply.

Speaking in Jerusalem, King said, "Even though some slowdown in the growth rate of economic activity is likely to be necessary to ensure that inflation returns to the target, we cannot allow the economy to slow too sharply, lest a margin of spare capacity is produced that pulls inflation down below the target next year." He described the MPC's inflation target of 2.0% as symmetric.

The BOE Governor also said financial institutions will be called upon to hold more capital and a greater quantity of liquid assets than it has up to now.

Also on Monday, UK�s Northern Rock has pledged to repay its �24 billion loan received from the Bank of England by 2010, despite issuing a warning that it would not break even for three years, according to a corporate statement. The outstanding loan amount was stated at �24 billion, while conservative market estimates put it at �25.6 to �26 billion, which suggests that some portion of the original amount may have been already been repaid.

By Stephen Huebl, edited by Cristina Markham