Two Roads Diverged

Story Highlights:

• Both the UK and EU face slightly higher than targeted inflation and slowing economic activity.
• In response, the Bank of England chose to cut rates to help stimulate the economy, and the European Central Bank chose to keep rates unchanged to help maintain price stability.
• Although both moves were widely expected and relatively minor, investors should be aware of global central bank activity and not just US Fed activity.
• Ultimately, such small, widely anticipated moves don't matter much, and regional inflation isn't rampant nor is any nation in dire economic peril.

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Two roads diverged in monetary policy. The Bank of England took one road, thought to help stimulate economic activity, but bore the peril of potentially fueling inflation. The European Central Bank took the other road, which held promises of maintaining price stability, but was not without economic risk.

Bank of England Cuts Key Rate to 5%
By William L. Watts, MarketWatch

European Central Bank Remains on Hold
By William L. Watts, MarketWatch

The Bank of England cited worsening credit and economic conditions as reason to lower rates by 0.25 percentage points to 5%, attempting to inject more liquidity into the British economy. Fearing accelerating inflation pressures, the European Central Bank kept rates unchanged at 4%. While there isn't necessarily an exact tradeoff between economic growth and inflation (the last two and a half decades featured solid growth and falling inflation globally), the difference in moves highlights the British and Eurozone central banks' differing primary fears and mid-term economic outlooks.

Both moves were widely expected and largely priced into markets. The recent weakness of the pound is likely tied to the anticipation of these moves. Still, investors should be aware of central bank activity globally and not just US Fed activity. Ultimately, such small, widely anticipated moves don't matter much and are reflective of fears—regional inflation isn't rampant nor is any nation in dire economic peril. On balance, short-term interest rates in Europe and the UK, much like the US, remain in benign territory.

However, that's not to say all economies in the region are doing fine or that the ECB's monetary policy is appropriate for all 15 member countries. Spain and Italy are both using fiscal measures to support their slowing economies, but probably would have liked lower rates to further help stimulate recovery. The ECB faces inherent divisiveness over its monetary policy, because despite the economic targets set for Eurozone countries, individual economies contrast in their growth.

European Growth Rates Pull in Different Directions
By Ralph Atkins, Financial Times

The ECB sets rates based on broad economic data for the entire region—meaning EU countries greatly diverging from averages, both below and above, can't rely on monetary policy to suit their individual economies. Central banks facing dramatically slowing economies often choose to lower rates, even if inflation is above desired levels. But since the ECB sets monetary policy for the Eurozone, countries like Italy and Spain are unable to make the choice between helping stimulate domestic economic growth and curbing inflation.

The ECB reasons setting monetary policy to maintain price stability, rather than to support economic activity, is the correct move because the Eurozone overall has proven resilient to the effects of the global financial markets turmoil. But recently, its €25 billion auction of six-month funds attracted €103 billion of collateral in orders from 177 banks—evidence some Eurozone members are seeing worse economic conditions than the broader picture captures. And with the ECB mandating rules and targets for its member countries, fiscal and economic policy in individual countries can only be conducted at limited levels.

For now, the small moves made by these central banks don't matter much and needn't warrant extra credence. But the roads taken by any central bank, no matter how few steps trodden down the path, deserve attention from global investors. As Robert Frost poetically suggested in The Road Not Taken, one road can sometimes lead to another, and those first few steps can make all the difference.