Further rates cuts not ruled out, but unlikely

May 28 2008 by Iain Laing, The Journal

INTEREST rate cuts always make the headlines. But central banks’ decisions on interest rates are rarely as simple as they might seem, and the financial markets can misinterpret the reasons behind them.

So, in an attempt to better communicate these reasons with the markets, a number of central banks – notably the US’s Federal Reserve and our own Bank of England – publish the minutes of their own internal monetary policy meetings.

These minutes tend to be published a few weeks after the relevant meeting, so not to unsettle the markets. Even so, while they might not, therefore, present a totally up-to-date view of current thinking, they still provide some interesting insights about how a decision was reached. And, by spelling out voting patterns and the views of specific individuals, they may give some indication of what lies ahead.

During April, the Federal Reserve cut interest rates by 0.25 percentage points while the Bank of England’s Monetary Policy Committee (MPC) kept them on hold. The minutes for both the relevant meetings were published last week, and although similar themes (eg higher inflation) run through both documents, there are some differences in emphasis.

The Federal Reserve’s decision to cut rates was clearly a close call. Several of its Open Market Committee opposed the decision, and the committee’s own view, as expressed in the minutes, was that it was no longer appropriate to “emphasise the downside risks to growth”.

The Federal Reserve has been revising downwards its own forecasts on US growth for 2008 as a whole, but continues to expect a rebound in the second half of this year. Hence there is a desire not to rush into further interest rate cuts too soon, particularly as the Federal Reserve has now raised sharply its inflation rate forecasts.

The MPC’s decision on interest rates was much more clear-cut. Eight members voted against a cut, with only one in favour. Fears about inflation evidently dominated the MPC’s thinking. (The MPC meeting followed April’s 3% year on year rise in the consumer price index, and the publication of distinctly hawkish inflation forecasts by the Bank itself.) The MPC was, therefore, at pains to highlight its commitment to get inflation back within the target range. As a result, the markets have now shifted their views on future UK rate cuts, and now don’t expect any for some time.

But although both the Fed and the Bank of England have emphasised that further interest rate cuts are unlikely, they cannot be ruled out. In the US, growth will be boosted in the short term by the impact of current tax refunds, but the effects of these may start to fade later in the year, tempting the Fed into a further cut.

And in the UK, we believe that a weakening domestic economy should ease underlying inflationary pressures over the next few quarters, giving the Bank of England some leeway to cut rates before the end of this year. In short, the current rate cutting cycle may not be over.

Andrew Miller is regional office head of Barclays Wealth