Round 1 begins in my anticipated interest-rate-driven race to the bottom between global currencies --
In an about-face, central banks may start cutting rates
By Simon Kennedy and Rich Miller
Bloomberg News
PARIS: Central bank chiefs, including those in Britain, the euro zone and Canada, may follow the U.S. Federal Reserve chairman, Ben Bernanke, in an about-face, shifting toward supporting economic growth and away from fighting inflation.
Economists are scrapping forecasts for higher interest rates in the euro zone, Britain and Canada as prospects for expansion weaken, and some even say inflation will soon recede enough to permit cuts. A similar change in outlook may delay expected rate increases in Japan.
"Led by the Fed, central banks are having to change course to avert a U.S.-led global downturn," said Paul Sheard, chief global economist at Lehman Brothers in New York.
Evidence may come this week as the European Central Bank and the Bank of England each hold policy meetings Thursday. While economists said they did not expect rate cuts this soon, Jean-Claude Trichet, the ECB president, and Mervyn King, the governor of the Bank of England, might use the opportunity to signal greater unease about growth. London home prices are falling by the most in three years, while the rise of the euro to a record high against the dollar erodes profits at businesses like Total, the French oil company.
The risk is that, with oil prices above $80 a barrel, rising food costs and limited spare production capacity, a tilt toward easier credit might end up fanning inflation. After the Fed on Sept. 18 cut its benchmark rate a half percentage point, more than forecast, investors took out inflation insurance by shifting money from bonds into commodities and emerging-market stocks that tend to perform well when prices are accelerating.
The price of gold ended last week at a 27-year high of $750 an ounce. Emerging-market stocks have rallied almost 20 percent in six weeks, according to an index compiled by Standard & Poor's and Citigroup.
"The problem in cutting interest rates in the current environment is that markets respond by raising inflation expectations," said Joseph Stiglitz, a Nobel-laureate economist at Columbia University. "That's a limitation for monetary policy."
For now, Europe's biggest central banks are standing pat.
Economists polled by Bloomberg News are nearly unanimous in predicting the policy meetings in London and Vienna this week will end with the British benchmark rate holding at 5.75 percent and the euro zone's at 4 percent.
Economists are changing their view of where the ECB and Bank of England will go from here. Just weeks ago, the consensus was that they would only pause in their drive to push rates higher. That view was reinforced by anti-inflation rhetoric from central bankers themselves. Now, as credit-market turmoil in the United States spreads overseas, the pause looks more like a peak.
"We've seen a major change in the gestalt, where the larger risks today are on the side of credit crunch, financial contagion, economic slowdown, rather than the pattern of increased inflation," said Lawrence Summers, the former U.S. Treasury secretary, now a professor at Harvard.
With loans harder to get in Europe, economists at Goldman Sachs and Lehman Brothers shelved forecasts that the ECB would raise rates. Lehman calculates that the rise in the cost of credit in European markets has the same effect on growth as a half-point rate increase by the central bank.
Exporters to the United States are also suffering as their local currencies surge, with the euro reaching a record $1.4278 last week. Total calculates that every 10-cent drop in the dollar against the euro shaves €1.1 billion, or $1.57 billion, from its operating income. The Canadian dollar in September traded at parity with the U.S. currency for the first time since 1976, prompting Tembec, a forest products maker based in Montreal, to close sawmills in British Columbia.
The U.S. economy's slide has come "faster and more furiously than expected," said Erik Nielsen, chief European economist at Goldman Sachs in London, who forecasts growth in the euro area and Britain of about 2 percent next year, the weakest pace in three years.
David Brown, chief European economist at Bear Stearns in London, projects the ECB will lower rates in the first quarter of 2008 "with more signs of economic confidence starting to fracture."
Rates may fall sooner in Britain, where King extended emergency financing to the mortgage lender Northern Rock to remedy a "severe liquidity squeeze" just weeks after saying he saw no "international financial crisis."
Michael Saunders, chief West European economist at Citigroup, said, "The run on Northern Rock highlights the U.K. economy's high vulnerability, especially via the housing market, to the crisis in markets." He said he expected the Bank of England, whose benchmark rate is the highest in the Group of 7 industrial nations, would start cutting as soon as November.
Lower borrowing costs might also be in store in Canada, whose central bank on Sept. 5 stopped referring to a need to increase its 4.5 percent benchmark rate and said market turmoil threatened growth by slowing export demand.
In Japan, where the economy contracted in the second quarter, economists pushed back predictions for when the Bank of Japan would raise its 0.5 percent benchmark rate, the lowest in the G-7.
Not every central bank is doing an about-face. In China, the fastest inflation in a decade may prompt higher interest rates. Norway last week raised borrowing costs for a sixth time this year amid a labor shortage. Price pressures have led Chile, Switzerland and Taiwan to raise their benchmark rates since early August, and each may do so again before the year ends.
Rich Miller reported from Washington.
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