The monetary policy crapshoot

The ECB is almost certain to raise interest rates this week. This action had been flagged last month by Mr Trichet. But what will be of greater interest is whether the accompanying statement and press conference hint at further rises, or whether this is to be a one off. The forward market has become more hawkish and is now pricing in 130bp in rate rises over the next 12 months.

And where the ECB goes, it looks likely that the Bank of England will have to follow. The UK economy last week showed that it is suffering from stagflation, with real GDP growth confirmed as having slowed in Q4 2010, contracting 0.5% q/q.

While the poor performance was mainly due to poor weather, the data also showed that underlying activity has stalled. Clearly, this is not a good starting point for the expenditure cuts and national insurance increases which will come through in Q2. However, retail price inflation is a very real problem running at 5.5% y/y – the highest level since July 1991. The Bank of England may well prefer to wait until the impact of the cuts is felt, but the stickiness of inflation could force their hand sooner.

The biggest crapshoot in the next few weeks will concern the actions of the Bank of Japan (BoJ), which has increased its current account balances (part of the monetary base, or high powered money) to JPY 40.8tn. This is equivalent to USD 485bn, or about 26% of US M1 money supply. It is reported that the Japanese central bank will act to withdraw this accommodation by the end of April, which if true could be disruptive to markets. With the yen now seen increasingly as a carry currency, the actions of the BoJ have almost certainly boosted global liquidity

One theme that could concern markets is inflation, which could build if the BoJ does not withdraw liquidity in a timely fashion. There have been a number of disappointing inflation announcements in the past weeks, including from the UK and from the eurozone, where headline inflation was well above consensus at 2.6% y/y in March. Our Deflation Alert Measure, which looks at market-related variables to gauge concerns over inflation or deflation, has been concerned about inflation recently.