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Last Updated : Feb 24, 2011 10:13 AM IST | Source: Reuters

Europe mulls higher higher rates; Fed seen on hold

European central banks appear to be edging closer to interest rate increases as inflation runs above targets, although fears of stifling fledgling recoveries may yet give policy makers pause.

European central banks appear to be edging closer to interest rate increases as inflation runs above targets, although fears of stifling fledgling recoveries may yet give policy makers pause.

Two hawkish Federal Reserve officials on Wednesday expressed some sympathy for concerns about higher prices, though the consensus at the US central bank still appears to favor a continuation of its highly stimulative monetary policy.

Complicating the outlook is a surge in crude oil prices due to escalating violence in OPEC producer Libya, adding to worries of a longer-term bump in inflation that could hamper a global economic recovery.

Market expectations for when the Bank of England and the European Central Bank will move have come forward sharply since the end of last year, and a poll Wednesday showed more economists moving to expect a rise in the third quarter.

Minutes released on Wednesday from this month's meeting of the Bank of England's board, facing inflation of more than twice its 2% target, showed three of its nine policy makers now want a rate rise. Other members signaled they were getting closer to supporting a move as long as the economy recovers from a year-end slump.

In the United States, however, the monetary authorities remain inclined to complete the Fed's second round of quantitative easing, known in the markets as QE2, at its June deadline.

Expectations that rates in Europe could rise ahead of rates in the United States was seen contributing to weakness in the dollar, which was down about 0.5% against a basket of major currencies on Wednesday.

The bar appears relatively high for further Fed bond buys, in part because of charges the central bank is printing money to fund the US government's budget deficit.

Kansas City Fed President Thomas Hoenig, who has firmly dissented against the central bank's bond purchase program, reiterated his call for rates to rise modestly to preempt future bubbles. "You have to calibrate your monetary policy with the recovery in the economy so you don't overshoot and cause the next crisis," he said after a speech in Washington on Wednesday.

At the same time, Philadelphia Fed President Charles Plosser showed little appetite for any extension of the controversial USD 600 billion bond purchase program. Plosser did not appear worried, however, that recent spikes in commodity prices would channel through to the costs paid by consumers.

"Commodity price increases do bear watching. I don't think these things cause inflation, but they may be symptomatic of incipient inflation; that's harder to tell," he said.

US crude surged to a 28-month high of USD 100 a barrel on Wednesday as escalating violence in OPEC producer Libya slashed output there and investors bet the unrest could spread to other oil exporters.

MPC hawks dominate

While unrest in the Middle East has only added to banks' worries that soaring oil and food prices will lead to a longer-term bump in inflation, economists say every USD 10 rise in the cost of a barrel of oil can also knock a half-point off economic growth -- weakening the demand side push on prices.

"Recent upbeat business surveys and hawkish comments from Governing Council members suggest that the balance of risks to our forecast is tilted toward an earlier ECB rate hike," said Nick Kounis at ABN AMRO.

Median forecasts of economists, rather than investors, still show most rate hikes delayed until the end of the year. That relates largely to worries that the biggest spending cutbacks in a generation -- and a full-scale debt crisis in Europe -- will knock economies back.

The British economy contracted 0.5% in the final three months of 2010, and while the BoE needs to defend its inflation-fighting credibility it does not want to further derail a fragile recovery from the worst recession in decades.

The median of a Reuters poll Wednesday showed the ECB also not shifting from record lows until at least October, effectively giving governments in the euro zone more time to deal with its debt and banking problems.

"We think that the ECB will at least await the results of (a planned new) bank stress test before pulling the trigger on a rate hike," said Peter Vanden Houte at ING.

That makes the start of the fourth quarter a plausible time to begin thinking about rate hikes, particularly since that would give the ECB time to communicate its intentions to the markets through its September forecasts for growth and inflation.

East-west divide

Although US economic growth is outstripping growth in the the euro zone, concerns over jobs and growth look set to keep the US Federal Reserve on hold for longer.

More clarity could emerge from the views of Fed Chairman Ben Bernanke, who will deliver his semi-annual report on monetary policy to Congress in two sessions of testimony next week.

Policy makers further east and in emerging countries are already well ahead of the major western central banks in their approach to tighter policy.

The Reserve Bank of Australia has been one of the most preemptive in the developed world, lifting rates by 175 basis points since late 2009 as its huge resource sector rides a wave of high prices, fueled by demand from China and India.

China on Friday also raised required reserves to a record 19.5%, adding to an increasingly aggressive effort by Beijing to stamp out stubbornly high inflation.

That was the fifth increase since October and will force the country's lenders to lock up a bigger chunk of their deposits at the central bank, removing cash from the fast-growing economy that otherwise would be pushing prices higher. The move followed an acceleration in inflation to 4.9% in the year to January.


First Published on Feb 24, 2011 10:04 am