In a recent poll, economists said they expected the US economy to grow at a rate of 2.7 percent this year which is the slowest since 2002, and indeed an improvement in last year’s prediction of a 2.5 percent rise as inflationary pressures ease. In their own minds, they believe strong consumer spending will offset the slipping housing market. Moreover, the annual rate of inflation is expected to drop below 2 percent to its lowest level in five years.
The anticipated fall to 1.9 percent from 3.2 percent in 2006 was a direct result of the sharp fall in energy costs as oil prices remain well below last year’s high of $78 a barrel. Looking ahead however, growth of 3 percent is forecast for 2008, which is an improvement this year, but still below 2006’s 3.4 percent figure.
Consequently, and not surprisingly, the anticipated decline in economic growth from 2006 has led to a decline in market interest-rate expectations. As it currently stands, the markets are now anticipating the Fed to eventually cut rates twice, from 5.25 percent now, to 4.75 percent by the end of the next year. The question is one of timing: when is the Fed expected those rate cuts occur? Last November the markets expected the Fed to cut its rates twice before September this year, and rates were expected to remain broadly unchanged until the end of 2008. While this scenario is still for rates to be at 4.75 percent at the end of the next year, it is now predicted that the two rate cuts will not occur until around the end of this year — roughly six months later than before. Let’s take a contrarian view: there are some analysts who predict the Fed will cut rates a bit more aggressively than the consensus — to 4.5 percent by the end of 2007. This implies the first cut coming sooner, perhaps by the time Fed meets in late June.
There is also the chance that there will be more evidence available showing that the moderation in the pace of home-equity appreciation is causing households to save more and spend less. Given this argument, it would be a less reason to suspect that the Fed will wait any longer.
Europe is a different story! The European Central Bank (ECB) has responded to the recovery in the euro zone economy by raising interest rates six times in just over a year. Despite this however, it has stuck rigidly to the view that interest rates remain low, suggesting perhaps that its work is far from done.
There are undoubtedly some good reasons to think that euro zone interest rates might be close to, or even at, a level consistent with low and stable inflation numbers over the next few years. Not only does there seem to be some slack in the economy, but various factors may have had a downward influence on the neutral level of interest rates in recent years.
At the same time, the interest rate-sensitive elements of the money supply are no longer growing at inflationary rates of expansion. Given these points, some economists would argue that interest rates are already no longer growing at inflationary rates of expansion and further their argument that interest rates are already no longer low. However, as long as the ECB itself remains of the view that interest rates are low, there would seem to be a danger that it will yet push them significantly higher. At a minimum, rates are expected to rise to 3.75 percent in March and another possible increase to 4 percent looks thereafter. But there might be reasons not to take the ECB’s hawkish signals on the subject entirely at face value. After all, even if it believes that interest rates are almost high enough, it is unlikely it wants to give a clear signal to that effect to consumers.
In the last major tightening cycle of 2000 and 2001, the ECB stuck to the line that interest rates were justifiably low and, accordingly, many expect 4 percent to be the peak of this interest-rate cycle. This level could even be higher than is absolutely necessary to keep inflation in line with the ECB’s target over the medium term, suggesting scope for interest rates to perhaps come back down a little next year — a prospect not yet being seriously considered by the markets. Indeed, the further rates raise above current levels, the greater the likelihood that they will fall again in 2008.
Here in the UK, the sharp drop in retail sales last month suggests that household spending growth is very likely to slow in the first quarter of 2007. Furthermore, and with investment perhaps unlikely to match the surge in the 4th quarter, GDP growth could start this year at a rather slower pace. The drag from net trade, which was relatively small (0.2 percent in 2006) may increase
this year as the global demand environment weakens and the strong pound takes effect.
As such, many economists expect GDP growth to be rather weaker that the 3.1 percent rate expected by the Monetary Policy Committee (MPC) this year.
The MPC appears to have raised its estimate of the sustainable rate of GDP growth recently in response to the effects of immigration and rising participation in the labor market. Notwithstanding its response, the committee has recently put more emphasis on estimates of market output and the demand for resources, which have been growing a bit more quickly than GDP itself. Consequently, for now at least, the more aggressive voices on the MPC will point to the continued strength of demand as a reason to lift interest rates at least once more in this cycle.
