July 2008

Early June saw central banks appear to finally make up their mind about the dilemma of whether to tackle inflation and jeopardise growth or risk inflation by maintaining a relatively loose monetary policy. To judge by the most recent rhetoric from the monetary authorities, the battle to bring inflation under control seems to have begun in earnest.

Having earlier cut rates dramatically, not only to support the slowing domestic economy but also to shore up a fragile financial system still reeling from the aftershocks of the US housing downturn, this is something of a volte-face for the US Federal Reserve. Latterly, Fed comments indicate that it is prepared to mitigate the worst that rising food and energy costs can inflict on the economy, although it has so far stopped short of tightening monetary policy and is probably hoping that reduced consumer demand, due to inhibitive price rises, will help defuse the inflationary time-bomb.
 
On this side of the Atlantic, the European Central Bank and the Bank of England have been less willing to rescue their respective financial sectors (which have, so far at least, been less adversely affected by the credit crunch than their North American counterparts) and both have, more or less consistently, maintained policies aimed at containing inflation rather than accommodating economic growth. Despite holding interest rates at 2% at its last Federal Open Market Committee meeting on 25 June, there are signs that the Federal Reserve is edging towards a similar strategy to the ECB. However, this is a conclusion that may be premature, since it should be remembered that, as opposed to the ECB's mandate to contain inflation above all else, the Fed has a dual mandate to balance inflation and growth, and there is at least some evidence that the impending US slowdown may not be as severe as some analysts have predicted. 
 
Nevertheless, the persistent strength in the price of oil and other commodities has led to expectations that interest rates are set to rise across the board, not only later this year but also in 2009. If this is indeed the case, and although a concerted central bank attack against inflation may be welcomed from a longer-term economic perspective, investors will have to brace themselves for a medium-term market environment in which prospects are potentially rather lean. Equity investors in particular are worried about the impact higher interest rates will have on economic growth and, by extension, corporate earnings, and they are now adjusting to the realisation that stocks were earlier trading on forward earnings projections that were arguably never realistic.