Central Bank Watch: Banks in Wait-and-See Mode, Some Moves Expected by Year End

Another round of major world central bank decisions are out of the way, yet rates are still where they were at prior to the decisions. However, many economists expect at least some of the banks to start moving on rates before the end of the year.

The U.S. Federal Reserve surprised no one when it left rates unchanged at 2.00% before releasing a statement balanced between a concern for slowing growth and elevated inflation levels.

The European Central Bank and Bank of England left rates on hold last week as both continue to struggle with rising inflation against a backdrop of weak economic growth.

The Reserve Bank of Australia also left rates on hold last week as Australia's once robust economy begins to show signs of moderation.

The Bank of Japan is next with its rate decision later in the month, though markets are nearly fully priced in for a hold as well as the BOJ deals with the increasing probability of a moderate recession.

U.S. Federal Reserve

Current Rate: 2.00%

Next Rate Decision: Sept. 16

Market Expectations: The OIS implied rate suggests markets are 2% priced in for a 25bp hike at the next meeting, and are pricing in a 38% chance of a quarter-point hike by the end of the year.

The Federal Reserve announced last week it would hold the Fed funds target rate at 2.00%, as was widely expected. The accompanying statement was balanced between a concern for slowing growth and elevated inflation levels. In the growth paragraph, the Federal Open Market Committee (FOMC) noted that economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports but that "financial markets remain under considerable stress".

On inflation, the statement said energy and commodities prices have pushed inflation to "high" levels, which should moderate this year and the next, "but the inflation outlook remains highly uncertain." The only dissenting voice in the FOMC decision was Dallas Fed President Richard Fisher, who preferred an increase in the target rate. This is the second consecutive meeting at which Fisher has called for a rate hike.

"The tone of (the) FOMC statement accompanying the widely anticipated decision to leave rates on hold was marginally more dovish than in late June, but the Fed is still leaving its options open with a neutral bias," noted Julian Jessop from Capital Economics.

He noted that the statement was little changed from the late June meeting, but that it did acknowledge the recent falls in commodity prices - if only partially. "Last time the statement referred to 'continued increases' in energy prices, but now these prices are simply 'elevated'," he wrote, adding that he does not foresee a hike in rates until mid-2009, though possibly one more cut in the meantime.

Just prior to the FOMC meeting, former senior executive vice-president and chief operating officer of TowneBank, Elizabeth Duke, was sworn in as governor of the U.S. Federal Reserve. Duke was nominated as a Fed Governor on May 15, 2007, following the resignation of Susan Schmidt Bies on March 30, 2007. She was confirmed by Congress on June 27 of this year, but was officially sworn in Tuesday. Her term expires Jan. 31, 2012.

Looking ahead, Fed fund futures are showing a 70.5% chance that the FOMC will hold rates at the subsequent Oct. 29 meeting, with a 29.5% chance of at least a 25bp hike.

A report issued last week by CIBC economists says rising inflation will leave the Federal Reserve with little choice but to raise rates in 2009, and that they expect to see a cumulative increase of 200 basis points during the year. The report forecasts the Bank of Canada to raise rates by a cumulative 100 basis points over the year.

Bank of Canada

Current Rate: 3.00%

Next Rate Decision: Sept. 3

Market Expectations: The OIS implied rate suggests markets are 34% priced in for the BOC to cut rates at the Sept. 3 meeting. Markets are fully priced in for a quarter-point cut by the end of the year, with a 49% chance of a 50bp cut.

In the wake of the worst monthly job loss figure since the early 1990s, markets upped the odds of a Bank of Canada rate cut at its upcoming Sept. 3 monetary policy meeting.

On Aug. 8, Statistics Canada reported that Canada lost 55k jobs in July, against forecasts for a modest increase of 5k. As well, the unemployment rate ticked up to 6.2% against expectations for it to remain unchanged from the previous month at 6.1%.

BMO economist Michael Gregory said the disappointing job numbers provided evidence that the Canadian economy is downshifting in response to the slowdown in the U.S. and the previous run-up in the Canadian dollar, but he noted there is not yet enough evidence to suggest the Bank of Canada will cut interest rates.

Charmaine Buskas, senior economics strategist from TD Securities, said the "stunningly bad number" should not markedly change the outlook, since it was "somewhat out of sorts" with other indicators, such as the BOC's business outlook survey. "It will bring forward expectations for a rate cut that the market has already priced in," Buskas noted. "We still think that this is an unlikely case, and we continue to argue that the Bank of Canada will not be in a position to make a move on rates until well into 2009."

The bank is also dealing with rising inflation, which was evidenced by the higher-than-expected inflation rate of 3.1% in June. However, economists said following that release that the BOC has already factored up to 4% inflation into its forecast.

On July 31, MF Global Canada bond strategist Levente Mady said inflation may rise for the next few months but will then cool and allow the BOC to lower rates. "As we move along, the arguments for a rate cut are going to get stronger," Mady said. "If anything, I don't think a rate hike is anywhere in sight."

Reserve Bank of Australia

Current Rate: 7.25%

Next Rate Decision: Sept. 2

Market Expectations: Markets are fully priced in for at least a 25 basis point cut at the next meeting, with a 27% chance of a 50bp cut. 93% chance of a hold, 7% chance of a 25bp hike (OIS Implied rate).

Markets are increasingly expecting the Reserve Bank of Australia to begin an easing cycle after six years of rate hikes.

On Monday, the Reserve Bank of Australia released its Quarterly Monetary Policy Statement, in which it said the "scope to move to a less restrictive monetary policy stance in the period ahead is increasing." That echoed the message policy-makers released on Aug. 5 following a decision to leave the cash rate a 7.25%.

"Recent indications are that a significant moderation in domestic demand is now occurring," the RBA said. "In addition to the effects of tighter financial conditions, other factors including a slowing in global growth, declining asset markets and higher fuel costs are acting to restrain domestic spending and activity." The RBA said that at the same time, high global commodity prices are adding to Australia's terms of trade, which is providing a "significant countervailing influence."

RBC Capital Markets strategist Su-Lin Ong said "the RBA's detailed quarterly SoMP confirmed an easing bias but there was little in the statement to support speculation of a more aggressive 50bp cut in September," she noted.

"Accordingly, risk reward argues for the RBA to begin its easing cycle sooner rather than later and we now expect the first cut at the upcoming September meeting (rather than October). While the debate over a 25bp or 50bp cut will wax and wane in the coming weeks both cases have merit," Ong added.

Working to hold back expectations was the June employment figure, which showed 10.9k jobs were added in the month against expectations for a more modest growth of 5k. Peter Pontikis, strategist from Suncorp, said July's employment report "may be just what is required to blunt the economic bears out there. Anything with a positive number one has to say really detracts from the near term rate easing case."

European Central Bank

Current Rate: 4.25%

Next Rate Decision: Sept. 4

Market Expectations: Markets are nearly fully priced in for a hold at the next meeting, with a 23% chance of a 25bp rate cut by the end of the year. (EONIA implied rate)

The European Central Bank is expected to remain on hold for the foreseeable future after bank president Jean-Claude Trichet confirmed the primary focus of the ECB is to contain inflation pressures.

As expected, the ECB decided to keep its main refinancing rate unchanged at 4.25% last week and, in the subsequent press conference, Trichet highlighted that inflation levels would remain high for a protracted period of time.

Trichet also said labour costs had been growing over the past quarters and that the central bank would be monitoring wage negotiations "with particular attention." In a question and answer session, Trichet reiterated that the ECB never pre-commits and that the ECB has no bias regarding rates.

"The ECB is in a 'wait and see' position, to assess new information regarding the outlook for inflation and economic growth," said J�rgen Michels, an analyst from Citigroup. "In toughening the language regarding indirect effects of the rise in food and energy prices, the ECB remains a hawkish tilt."

Calyon Research senior FX strategist Stuart Bennett added: "Given that Trichet repeated that the Bank's sole focus, in line with its mandate, is to contain these inflation pressures, the risk of another rate hike cannot be ruled out."

Lloyds TBS economist Kenneth Broux said the ECB, like the Bank of England, faces "one of the most challenging periods since its inception, with conflicting growth and inflation trends demanding a very patient policy stance."

"However, the nature of the Bank's mandate stipulates that inflation is the top priority and with so much uncertainty of when CPI inflation eventually starts to slow, the Bank has no other option but to keep interest rates at 4.25%, regardless of the worsening growth backdrop," Brouz added.

In an interview with German newspaper Stuttgarter Zeitung published on Tuesday, ECB Governing Council member Axel Weber said he expects the inflation outlook in the euro zone to remain negative for a while and that the financial market crisis could last well into 2009. However, despite these sour forecasts, Weber stressed that there was no need for pessimism regarding the economy and speculated that inflation could fall below 2% this year and possibly into the next.

Also on Tuesday, ECB Executive Board member Lorenzo Bini Smaghi said the euro zone economy could recover if inflation could be brought under control, though said he still expects the European economy to remain weak over the next few quarters.

Last Friday, in an interview with Dutch broadcast channel RTL Z, ECB Governing Council member Nout Wellink said food and energy prices are rising sharply and added that the bank is very concerned about accelerating inflation in Europe. He also said the council broadly agreed to leave the main refinancing rate unchanged at 4.25% during its meeting on Aug. 7.

Bank of England

Current Rate: 5.00%

Next Rate Decision: Sept. 4

Market Expectations: Markets are currently pricing in a 31% chance of a rate hike at the next meeting. (SONIA implied rate)

Soaring inflation and weakening growth threatening to push the economy into recession was not enough to sway the Bank of England from its monetary policy stance last week, as the bank left the benchmark 5.00% interest rate unchanged.

The last interest rate move by the BOE was on April 10, when the bank delivered a 25bp cut.

However, with commodity prices continuing to decline and economic growth expected to hold back spending, many see scope for less hawkishness in the coming months.

Alexis Garatti at Natixis sees weaker economic growth in the UK as weighing in favour of rate decreases down the road. "The sharp deterioration of economic conditions in the UK � will prevent the BOE from tightening its monetary policy despite inflation at very high levels and still expected on the upside," she wrote in a client note. "We expect the status quo until February 2009. From that date, the BOE could envisage to ease the monetary policy (two 25 bp cuts in February and May 2009)."

On July 14, Bank of England Governor Mervyn King said in the bank's annual report that the MPC can have little impact on the path of inflation in the short term. "It has not attempted to prevent inflation moving away from the target following the sharp rises in commodity prices. To do so would have required a large increase in interest rates with such a severe impact on output and employment that it would have risked inflation falling well below target further out," he added.

Last week, the International Monetary Fund issued a report on the UK that paints a picture of an economy that is slowly hemorrhaging amid soaring inflation and declining growth. The IMF report forecasts that the UK economy will grow by 1.4% in 2008 and just 1.1% through next year.

Bank of Japan

Current Rate: 0.50%

Next Rate Decision: Aug. 19

Market Expectations: 97% chance of a hold, 3% chance of a 25bp hike (OIS Implied Rate).

With inflation continuing to trend higher and prospects of slower economic growth, economists and markets are nearly fully expecting the Bank of Japan to leave its benchmark interest rate unchanged at 0.50%, where they have been since January 2007.

"The Bank of Japan (BoJ) is in no more hurry to intervene than it has been over the past few months," economists from Desjardins recently wrote in a client note. "If we exclude energy and fresh food, inflation continued to dwell in negative territory: -0.1%. Moreover, high oil prices and the American economic slump are increasing the risk of recession in Japan."

On July 29, the BOJ released data showing a worsening labour market, with unemployment ticking up to 4.1%.

Despite the dire outlook, BOJ Deputy Governor Nishimura said in an interview published in the Mainichi newspaper on July 29 that although the economy may be headed for a recession, a sharp downturn is the only fear, and that this outcome is unlikely.

On July 24, BOJ board member Atsushi Mizuno said the government could soon announce a moderate recession in Japan. "The fog hanging over Japan's economy will stick around for the time being," Mizuno said, citing weakening consumer spending data. The adjustment should not be too deep in Japan, he added.

Delivering a speech at the Bank of Japan's quarterly branch managers' meeting on July 6, BOJ Governor Masaaki Shirakawa maintained his position that growth should continue to slow in the coming months before resuming a moderate expansionary path.

The central banker cited the soaring cost of crude oil and other raw materials, noting an upward trend in worldwide inflation. Nevertheless, Shirakawa pledged that the Bank of Japan would act appropriately and flexibly, paying close attention to the downside risks to growth.

By Stephen Huebl and edited by Nancy Girgis