Economists and markets not so far off on rates

Interest rate futures markets are gyrating more than they have in many years but the gap between what fast-money traders and cerebral economists expect is not as wide as many now think. Analysis of the past year of Reuters polls against market pricing for the end of 2008 shows that the two were most out of line late last year when markets were factoring in rapid cuts and economists were saying "yes, but not so fast!" This holds for expectations for moves in official eurozone and British interest rates as well as for the US Federal Reserve, when markets just six months ago were pricing in two more interest rate cuts from the current two per cent.

On Tuesday, they were retreating sharply from pricing in 100 basis points of hikes to three per cent just last week, in part from the perception that well-timed articles in the financial press contained official hints from policymakers.

But some economists who have been in the forecasting business for many years say that the multi-directional bloodbath in rate futures in the US, eurozone and sterling markets is a clear signal of a turn in the interest rate cycle, not discord.

"It seems fairly typical," said Stephen Lewis, chief economist at Monument Securities in London, who has been forecasting interest rates for 38 years. "You often get this discrepancy of view at a turning point in policy."

Widespread concerns that global inflation is rising, driven by huge spikes in food prices and record oil prices, have overtaken worries that the US economy will slip into recession and has many top central banks on high alert.

The maximum divergence between the Reuters poll median and the market view on US rates was in November last year when markets were pricing in 150 basis points of Fed rate cuts from existing levels and economists said they would only do 25.

The gap between the markets and analysts is only half that wide now, and narrowing sharply on Tuesday as markets retreated from the prospect of imminent Fed tightening. The same is true of the European Central Bank and the Bank of England.


In late 2007, in the throes of the credit crunch, the markets ended up being right on US rates. The Fed chopped rates by more than the 150 basis points they had been pricing for end-2008 and the year is only half over.

But it is a different story for the European Central Bank.

With the exception of ECB President Jean-Claude Trichet's heavy hint of an imminent rate hike to 4.25 per cent next month that took the markets completely off guard, the economists' track record is looking better for euro zone rates.

"Communication has something to do with it," said Klaus Baader at Merrill Lynch, one of a handful of economists not to have forecast any ECB cuts this year.

"The ECB has been pretty careful in this tightening cycle not to signal that this is an ongoing adjustment."

On the publication dates of the 35 Reuters ECB polls conducted since May 2007, markets expected rates would be below their current four per cent at end-2008 a total of 22 times. Economists as a group made that prediction only 12 times.

Both now agree they will rise in a few weeks.

The divergence between markets and the median forecast was wider for the Bank of England. A quarter point UK rate cut in December that triggered expectations of a series of aggressive cuts saw the average divergence soar to 125 basis points.

At the time, economists expected only a half percentage point more of cuts to five per cent by end-2008, which is where they are now and are likely to stay.

Median end-2008 forecasts for the ECB and BoE were within a one percentage point range over the past year. Financial market expectations were within a 1.5 percentage point range for the ECB and 2.25 percentage points for the BoE.

That may be partly because analysts by the nature of their work are slower to respond than markets. But some are very critical of their peers as a group for not waking up to the fact that policymakers on both sides of the Atlantic are now sounding much more concerned about inflation.

"They have been reluctant to accept reality because they work for institutions which have been affected by the sub-prime crisis and… that is colouring their view about the economy as a whole," said Trevor Williams at Lloyds TSB.

"Economists have not listened enough to what central bank policymakers have said, otherwise they would have already changed their views." (Reuters)