Economic and monetary environment
The Group’s earnings are affected by the economic and monetary environment in its key markets.
The UK interest rate cycle turned in 2006, with the Monetary Policy Committee (“MPC”) lifting the Bank Rate from 4.5% to 4.75% in August, and to 5% in November. Despite market expectations that there would be more to come from the MPC in 2007, longer-term interest rates were below the policy rate at year-end, as was the case for most of 2006 (e.g. the 10-year benchmark gilt yield was 4.74%). The Bank Rate was increased in response to the threat that stronger economic activity posed to the medium-term inflation outlook, and the risk that the energy-induced increase in CPI inflation during 2006 would dislodge expectations ahead of the 2007 wage bargaining round (CPI inflation was 3% in December 2006; the government-set target is 2%).
Even after 17 interest rate rises over the past two-and-a-half years, to 5.25%, monetary conditions remain fairly supportive in the US. A weak dollar and low long-term interest rates have partially offset the effect of a higher fed funds rate on economic activity – though 5.25% is not high by historic standards. The US economy grew by a respectable 3.4% in 2006, though sluggish growth towards the end of the year – largely attributed to a sharp slowdown in the housing and auto sectors – led markets to price in rate cuts in 2007. This helped to exacerbate the yield curve inversion that prevailed for most of 2006.
The European Central Bank lifted the Refi Rate to 2.25% in January 2006. Prior to that, the Refi had been on hold at 2% for two and a half years. Four more quarter-point increases followed, taking the Refi to 3.25% by year-end. Markets expect this ‘normalisation’ to continue in 2007, as the improved economic environment meant that ultra-low interest rates were no longer needed to stimulate demand.
Exchange rates are an important driver of monetary conditions; they also affect earnings reported by the Group’s non-UK subsidiaries, and the value of non-sterling denominated assets and liabilities. The pound rose by 25c against the dollar over the course of the year, or 14%, in response to the unexpected (at the start of 2006) increase in UK interest rates. Sluggish growth in the US towards the end of the year, and the market’s perception that this would lead to lower interest rates in 2007, also put downward pressure on the dollar.
© 2007