Inflation prompts market rethink on rates according to Bank of Ireland

Central Banks cannot affect current inflation and weaker activity implies lower inflation next year

“It does not seem long ago that financial markets were pre-occupied with the threat of deflation; the fear that falling prices would threaten the major developed economies, perhaps precipitating a prolonged economic downturn. The world has turned, and now some market commentators fear a significant rise in inflation, a concern that has prompted a substantial change in interest rate expectations. The market no longer expects rate cuts from the ECB and the Bank of England, and the futures market in the US is now priced for a half point rise in dollar rates by March 2009”, according to Bank of Ireland’s May Bulletin which was published today, 29 May 2008.

Author of the Bulletin, Dr. Dan McLaughlin, Group Chief Economist, Bank of Ireland said: “Despite this the outlook for economic activity has not improved. While first quarter GDP growth in the euro area was stronger than expected, this owed much to the vagaries of seasonally adjusted data from the German economy, with all the forward-looking indicators pointing to sub-trend growth in Europe in the year ahead. In the UK, the Bank of England now expects annual growth in the UK economy to have slowed to under 1% by the first quarter of next year, from the current 2.5%, and in the US the Fed has also revised down the near-term economic outlook.

“Inflation ultimately reflects the pace of economic growth relative to the economy’s potential, so all the major Central Banks are expecting inflation to fall in 2009, in response to sub-trend growth. This might lead one to believe that interest rates may indeed fall in those economies where they are now too high for these expected economic conditions, which includes the UK and the euro area, if not the US, where they have already seen a substantial monetary easing. Moreover, the time lags involved means that inflation today is not amenable to monetary policy, particularly when it is largely driven by external factors such as food and energy prices. Central Banks know this, of course, and therefore emphasise that they need to guard against ‘second-round’ effects, such as higher wage claims, and to ensure that people expect inflation to fall back again rather than continue at the current, temporary, higher level.

“Hence, the rhetoric to that effect, notably from the ECB. Wages are unlikely to accelerate in the face of slowing economic activity, however, so attention may well switch back to the economic outlook and its implication for inflation in a year or eighteen months time. Inflation also erodes real income and hence leads to weaker activity anyway, so it still seems that rates could well fall this year in the euro area and fall further in the UK, despite the current inflation rates. Remember in the last cycle the ECB started to cut rates in May 2001, when inflation was 3.1% and GDP growth 3.0%”, concluded Dr. Dan McLaughlin.

Ends

29 May 2008

For reference:

Dr. Dan McLaughlin
Group Chief Economist
Bank of Ireland Global Markets
Tel: (01) 609 3221

Anne Mathews
Media Relations Manager
Group Corporate Communications – Bank of Ireland
Tel: (01) 604 3836