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Central Bank Preview: Federal Reserve, European Central Bank, Bank of England All Set to Act

Central Bank Preview: Federal Reserve, European Central Bank, Bank of England All Set to Act

All eyes this week are on the three most important central banks in the world as the global economy continues to slow. The root of the global slowdown can be traced to Europe, whose drive to austerity has forced governments to curb spending, sending nations across the continent back into recession.

ECB President Mario Draghi last week indicated that the ECB is set to launch a new round of crisis fighting measures at its meeting this Wednesday and Thursday. Further rate cuts are a succinct possibility following last month's 25 basis point cut to the benchmark lending rate and 25 basis point cut to the deposit rate. Now, the ECB pays zero interest on deposits and the bank could cut the lending rate a further 25 basis points and could even make the deposit rate negative in efforts to spur lending.

The ECB could also launch a third round of Longer-Term Refinancing Operations (LTRO's), where the ECB offers cheap, 3-year loans to financial institutions in hopes that the money gets invested into sovereign bonds, capping yields. Speculation is also that the bank will loosen the collateral requirements on these loans, which could increase risk appetite into more risky bonds. Banks have been buying ultra-safe AAA rated bonds to use as collateral, driving down the yields on these bonds. Loosening collateral standards could allow banks to buy slightly more risky bonds, "normalizing" the yields on these AAA rated securities.

The Federal Reserve is also set to meet this week from July 31-August 1 and hopes of QE3 remain. However, it seems rather unlikely that the Fed will launch a new round of easing at this meeting for a few reasons. First, the Fed just extended Operation Twist in June and will most likely want to see the effects of this policy move before changing policy. Second, it is an election year, and the Fed has only changed policy four times in an election year in its history. Third, many of the economic headwinds facing our economy emanate from Europe or from the fiscal authorities, so monetary stimulus from the Fed may take the burden away from the real root causes and act as another band-aid solution. Lastly, inflation expectations remain too high to warrant further Fed easing.

Watch for the Fed to take a more negative tone in its post-meeting communique and also to potentially ratchet down its economic forecast. Such action tends to preempt any policy measures by one meeting or so. Most importantly, watch the Fed's inflation expectations in its forecast. At the last meeting, the Fed dropped its forecast for the rest of 2012 to 1.2-1.7 percent inflation on an annualized basis, well below the previous 2.2 percent. Also, the wide range indicates that the economists were unsure as to the future of prices and the weird weather recently will affect food prices in the medium-term. Easing is much more likely at the September meeting, after the Jackson Hole conference and also after the ECB, allowing Mr. Draghi to act first. All of these factors combined should create further uncertainty, not less.

Lastly, the Bank of England is set to release its interest rate decision and quantitative easing update on August 2 after a two-day meeting. The Bank is set to maintain its policy stance despite England slipping back into recession over the last few quarters and GDP growth plummeting in the second quarter. The bank could surprise markets by increasing its Quantitative Easing program again, however this is unlikely. The bank could also cut its rate by 25 basis points to 0.25 percent to spur lending.

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