Hawks circling over Europe

The Bank of England and the European Central Bank had been widely expected to raise interest rates in 2007, but markets were still taken by surprise last week by a decision by the BoE to raise interest rates.

On 11 January, the Bank of England's Monetary Policy Committee raised its official bank rate by 0.25 percentage points to 5.25 percent. In the statement accompanying its decision, the BoE cited steady growth in domestic demand and rapid growth in credit and broad money. With the margin of spare capacity in the economy appearing limited, it wrote that it is likely that inflation will rise further above the BoE target of 2 percent in the near term before falling back as energy and import price inflation abate.

With the latest hike, the BoE's benchmark rate is now on par with the Federal Reserve's federal funds rate, after having allowed the latter to overtake it as a result of the BoE's pause in 2004 followed by a rate cut in 2005 amid fears of a collapse in the housing market. It also keeps the yield curve well inverted, with the 10-2-year spread on UK government bonds currently at about minus 50 basis points.

However, the inverted yield curve seems to have had little adverse consequence so far, and the feared collapse in the housing market did not happen. Indeed, the housing market has roared back to life, surely a factor behind the BoE's latest decision to raise rates again.

In addition, the inflation rate had hit 2.7 percent in November, a rate not seen in a decade. Indeed, many analysts speculate that the inflation rate for December, not yet officially released but already known to BoE members, could have breached the 3-percent threshold that would force the BoE to write a letter of explanation to the government.


Whatever it was that prompted the rate hike, it must have been something substantial enough to have spooked the BoE into springing a surprise on markets. And that in turn raises the probability of yet more rate hikes to come.

In contrast to the BoE's rate hike, the ECB's policy decision on the same day proved less of a thrill. No change was announced on interest rates, but ECB president Jean-Claude Trichet did drop a strong hint at a briefing in Frankfurt: "I would not say anything here that would change expectations in the market that we could do something at the end of the first quarter."

Indeed, the surprise would be if the ECB did nothing by then. Although the inflation rate in the euro zone was relatively subdued at 1.9 percent in December, Trichet noted that money and credit growth remains "very strong". In fact, Trichet pointed out that the November M3 growth rate of 9.3 percent was "its highest annual rate of growth since the introduction of the euro and, indeed, its strongest aggregate growth in the euro area group of countries since 1990". The 11.2 percent growth rate of loans to the private sector in November, unchanged from the previous month, was further evidence of the rapid rate of monetary and credit expansion.

Trichet concluded that "annual inflation rates are projected to hover around 2% this year and next, with risks to this outlook remaining on the upside".

In an answer to a question at the session, Trichet also commented that the ECB remains "very attached to the monetary pillar", saying that it "had served us very well". He said: "You remember that the OECD was advising us not to move, that the IMF was advising us not to move, that a number of market participants were giving us the same advice. We decided to move, we are now fully vindicated."

And such confident words can only mean one thing: More rate hikes to come from the ECB.