EU rates to stay low even as US and UK plan hikes

Wooden models of Euro symbols displaying on top of each other.

The news from central bankers in the past week suggests that the US Federal Reserve may be closer than markets think to hiking rates, while the Bank of England seems content to wait until next spring before it starts to tighten policy writes Oliver Mangan Chief Economist at AIB.

The Fed’s Dennis Lockhart, who is seen as a centrist representing the consensus view, said it would take a significant deterioration in upcoming economic data to convince him not to vote for a rate hike in September. His comments followed remarks by another Fed official, James Bullard, that the US is in good shape for a rate hike in September. The markets, however, do not expect the Fed to increase rates until December.

US data last week were generally good, with the ISM services index rising strongly in July to a 10-year high and the new orders component of the manufacturing ISM index increasing for a fourth consecutive month. Meanwhile, last Friday’s key employment report for July was solid, with non-farm payrolls posting yet another 200,000-plus increase and the unemployment rate remaining at 5.3%.

Nothing here then to deter the Fed from hiking next month if it is so inclined. Inflationary pressures may be subdued but the economy is close to using up any remaining slack. We also got a raft of news from the Bank of England last week. The upshot of it all is that, with inflation likely to remain around zero in the coming months, it is not in any hurry to hike interest rates.

Mark Carney, the governor of the BoE, did say that the timing of the first rate increase is drawing closer but the bank’s forecasts suggest that it will not move until the second quarter of next year.

UK unemployment is higher and core inflation lower than in the US.

Meanwhile, currency strength is having a much bigger impact on the UK than the relatively closed US economy, which is also less impacted by weak external demand. Fiscal policy is also much tighter in the UK, and official rates at 0.5% are also higher than in the US. For these reasons, the Bank of England is likely to lag the Fed in the rate-tightening cycle.

Both the US Fed and BoE, though, continue to emphasise that when they do start to tighten policy, they expect that it will be at a very slow pace. The view of markets is that three-month interest rates will rise to 1.8% in the UK and 2% in the US by the end of 2017, which would still be very low levels by historical standards.

These expectations will hopefully limit any fallout from the rate hikes in financial markets, which have become very used to an exceptionally low interest rate environment.

Longer-term interest rates have already risen from their lows earlier in the year in anticipation of policy tightening by some central banks.

Of course, markets do not expect any increase in eurozone rates in the next couple of years, with futures contracts pricing in a three-month rate of 0.2% by end 2017. The ECB has made it clear that it will continue to loosen monetary policy via its quantitative easing programme until at least September next year.

ECB rates are likely to remain on hold for a considerable period after the quantitative easing programme ends. Markets are looking for a small increase in ECB rates by the end of 2018, with three-month money rates expected to have risen to around 0.5% by then.

The main reason for such modest rate hike expectations is the subdued inflation environment, with inflation near zero in many countries. In this regard, there has been a renewed fall in oil prices in recent weeks, while world food prices in July fell to their lowest level in six years.

Inflation looks set to remain very low for some time yet.