Fed Policy Faces Test After Payrolls Data

Fri Aug 6, 2004
By Christina Fincher

LONDON (Reuters) - Soaring oil prices, fragile equity markets and a shockingly weak U.S. jobs report have put the following question on everyone's lips -- will the Federal Reserve dare to raise interest rates next week?

Second-quarter growth figures from Japan, Germany, France and Italy next week will be the highlights of the data calendar but are likely to be overshadowed by events in the United States.

The U.S. central bank raised interest rates for the first time in four years at the end of June, indicating the quarter-point hike to 1.25 percent would be the start of a "measured" campaign to return borrowing costs to more normal levels.

Surprisingly weak jobs figures on Friday, however, have challenged official optimism in the strength of the recovery and the Fed may think hard before raising borrowing costs for the second time in six weeks.

"With rates so extravagantly low I think the Fed will probably move next week but it's a tricky call," said Jim Webber, chief economist at Toronto Dominion Securities. "You can see from the market's reaction that not everybody agrees."

Stock markets tumbled and government bonds leapt on Friday after the Labor Department said only 32,000 new jobs were created in July, less than one seventh of what the market expected. The dollar fell almost two cents against the euro in a matter of minutes.

WORDS OF WISDOM?

How the Federal Reserve justifies its decision on Tuesday could have even more impact on financial markets than the decision itself.

So far, Federal Reserve chief Alan Greenspan has insisted the soft spot seen in the second quarter will be short-lived but analysts say it will be hard for him not to acknowledge the weakness of the labor market.

"The market will be looking for guidance from the Fed's statement," said Philip Shaw, chief economist at Investec. "The Fed believes most of the recent weakness will be just a passing phenomenon."

U.S. retail sales data next Thursday will be the next litmus test and could play a role in determining the future path of U.S. interest rates.

Economists expect retail sales to have rebounded in July after a sharp 1.1 percent fall in June.
A weaker-than-expected number could cause further financial market ructions since it would suggest high fuel prices are hitting the American consumer.

ASIAN TIGER

The Bank of Japan is expected to leave its ultra-loose monetary policy intact next week, even though figures on Friday are expected to show Japan's economy grew for a ninth consecutive quarter -- its best performance in about a decade.

Bank of Japan policymakers meet on Monday and Tuesday, but few in the market expect the bank to hit the monetary brakes before the end of next year.

"There is a clear growth story in Japan but the Bank of Japan is nowhere near hiking rates," said Brian Hilliard, chief economist at Societe Generale. "It is too aware of the mistakes of the past when rates were raised prematurely."

Analysts polled by Reuters expect Japan's economy to have grown by an annualized 4.1 percent in the April-June quarter in real terms.

This would represent a slowdown from even faster rates of growth in the previous two quarters but would keep Japan in pole position among other Group of Seven industrialized nations.

Japan's economic expansion is expected to have been led by rising capital spending and personal consumption.

Japan's government revised its own growth forecast higher last month and now predicts the economy will grow by 3.5 percent in the fiscal year ending next March, the fastest pace in eight years.

SLOW BUT STEADY

Data next week will show how quickly the euro zone's biggest economies grew in the second quarter. Germany, France, Italy and the Netherlands all release gross domestic product figures which will feed into an estimate for the bloc as a whole at the end of the week.

Analysts polled by Reuters predict the euro zone expanded by 0.6 percent during the second quarter to give an annualized growth rate of 2.0 percent.
"The numbers are likely to show that the euro zone's recovery is continuing but that growth remains sub-par," Investec's Shaw said.

German trade figures for June and French inflation data for July are also due for release but are not expected to provoke huge market reactions since there is little expectation of any change in euro zone interest rates this year.

In Britain, jobs data and the Bank of England's quarterly inflation report on Wednesday may shed light on how aggressively the Bank will raise interest rates in the coming months.

It raised rates on Wednesday to 4.75 percent, its fifth quarter-point hike in less than a year, but noted that there were signs rampant house price inflation and consumer borrowing were moderating.

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