Inflation fears transform interest rate prospects

With oil prices rising above $140/barrel, inflation has resurfaced as the primary policy concern. Though the credit crisis continues to weaken activity, hopes of early interest rate cuts have been abandoned.

Recent figures show annual increases in consumer price accelerating to levels widely seen as excessive and above target – 4.2% in the US, 3.7% in the eurozone and 3.3% in the UK.

Initial reactions to surges in oil and food prices have been muted, in the hope that we are dealing with a temporary spike. But core inflation is edging up and there are signs that expectations of future inflation are rising. If correct, this is ominous, because it indicates a worrying loss of public confidence in the central banks’ ability to control inflation.

The evidence of a major inflationary upturn is not conclusive. But the central banks have been sufficiently alarmed to signal a forceful change towards less accommodation. The futures markets have over-reacted and have priced three or four interest rate increases this year. But this is unlikely, given the risks of recession resulting from surging oil prices, falling house prices and the erosion in the banks’ capital base.

Rates
The traditionally hawkish European Central Bank, which has refused to cut rates since the credit crisis started, will almost certainly raise rates to 4.25% early in July. But officials have dampened clamour for a number of increases. The US Fed is moving more gradually, indicating that early cuts are out and has encouraged expectations of a small increase to 2.25%, but not immediately.

The Fed may wait until after the US presidential elections in November. In the UK, the markets predict higher rates in the next few months, but most analysts expect UK rates to stay at 5.00% this year.

In 2009, the eurozone and the UK may be forced to cut rates, because their growth prospects are worsening. But US rates may edge up next year, albeit from a lower base, because the US cyclical upturn is likely to start earlier. This also means a stronger US dollar in 2009.