Interested in global rates

Croesus/The Investor's View:Central bankers were at the forefront of developments this week with the Federal Reserve in the US leaving its policy rate unchanged at 5.25 per cent on Tuesday, while in London, the Bank of England released its closely-watched quarterly inflation report.

This was the ninth consecutive month the Fed chose to leave rates unchanged. This was as expected, although many market participants were looking for hints that a reduction may be just around the corner in response to the turmoil in the credit markets.

In its statement the Fed did acknowledge that financial markets had been more volatile in recent weeks and it noted both "tighter credit conditions for some households and businesses" as well as the "ongoing correction" in housing.

Although the US central bank stated that "the downside risks to growth have increased somewhat", it reiterated that "its predominant policy concern remains the risk that inflation will fail to moderate as expected".

The reaction in the US financial markets was volatile as stock prices initially fell but then rose to finish up on the day. The US dollar briefly fell but then recovered most of its losses later in the day.

It would seem that the Fed is not going to change its monetary stance in response to the weak US housing market and the credit markets in turmoil.

The US economy is still strong and inflation pressures have not yet abated sufficiently to justify a rates reduction. Indeed the Fed may be taking the view that the problems in the credit markets reflect a healthy repricing of financial risk.

Therefore, unless conditions deteriorate sharply, interest rate policy will continue to be determined by real economy factors such as inflation and unemployment.

Recent data on inflation has been positive with the core rate of consumer inflation slipping just below 2 per cent. The unemployment rate has ticked up marginally which suggests that medium-term wage pressures may abate somewhat.

So far the recession in the US housing market has not spilled over into the rest of the economy. However, with conditions still deteriorating in US housing, it seems inevitable that US consumer confidence will eventually be adversely affected.

Before Tuesday's meeting, interest rate futures markets were indicating that there was a strong chance of an interest rate cut before October. After the meeting the futures market implied a lower chance of a cut in the near term, but maintained an almost 100 per cent chance of a cut by year-end.

Croesus now takes the view that a quarter point cut in the Fed Funds rate is highly likely before year-end. If credit market conditions were to deteriorate sharply in the meantime, a cut could come sooner.

Would such a cut have any impact on euro interest rates? In the short-term probably not, as the ECB will continue to be driven by economic developments in Europe.

The Bank recently gave a strong hint that there would be another quarter-point hike to 4.25 per cent in the repo rate in September. The consensus is that there will be one more rise after that to bring the rate to 4.5 per cent, but that this would then mark the peak for this cycle, particularly if rates in the US had by then begun to decline.

Meanwhile in the UK, the Bank of England's inflation report, released on Wednesday, indicated that there would be one more hike in sterling rates to bring the official rate to 6 per cent. The report noted that British consumer spending was surprisingly resilient.

Overall, British rates should peak in early 2008 before falling back marginally later in the year.

For the Irish economy, these global interest rate developments are of greater significance than usual given current uncertainties.

After booming for more than 10 years, the Irish economy is currently moving towards a slower, more sustainable pace of economic growth. This has created substantial unease regarding the prospects for 2008, with the focus of attention on the interest rate sensitive housing sector. A benign interest rate environment would clearly be a welcome positive influence during this transition phase. This has become more likely and Croesus now believes that in 2008, US interest rates will decline and UK and euro rates will remain stable.

This would mark a substantial change from the rising rate environment of 2006 and 2007 and would shorten the odds of a soft economic landing for the Irish economy in 2008.