JPMAM global strategist, Tom Elliott asks - What's driving Europe?

On the face of it, the predicaments for the European Central Bank (ECB) and Bank of England (BoE) look similar: both have to keep a careful watch on rising inflation, while at the same time the underlying economies are slowing. Interest rates in both regions are far higher than the US (where rates have been cut aggressively) and Japan.

Looking a little more closely, however, different forces seem to be at work. This has been indicated by central bank rhetoric, with the BoE appearing to be more concerned about the economic impact of credit stress than its continental counterpart. Today's announcements illustrate this, with the ECB keeping interest rates at 4.0%, now unchanged since June 2007, while the BoE cut rates 0.25% down to 5.0%. Both announcements were consistent with market expectations, any prior doubts had concerned the ECB's statement, but President Trichet kept a steady course saying, "the sentiment of the governing council is the same as last time".

The currency markets have taken a very different stance towards the two regions. The euro has strongly appreciated in recent months, reaching another high against the US dollar today, while sterling's performance has been, well, less than sterling. Interestingly, headline inflation in the eurozone is also running almost one percent higher than in the UK, despite the strong euro.

Importantly, the sources of economic slowdown appear to differ. In Germany, the impact on real household incomes from surging food and energy prices seems to be a greater factor than the tightening credit market. This is reasonable enough, given that German households, and corporates, are net savers, and the German mortgage market is far less exposed to variable rates.

Meanwhile, the UK is suffering more from tighter credit conditions, with households significant net debtors. Most mortgage lenders have increased borrowing rates and cut back on the deals that they offer, which is denting household finances, confidence and house prices. The BoE's quarterly credit conditions survey, released last week, shows that lenders expect further tightening in the second quarter. Interestingly, Spanish households and corporates are also net debtors, well above the eurozone average, and are feeling the pinch from higher borrowing costs and tighter credit. Ultimately, however, as a member of the single currency, Spain must go along with the majority.

While the exact circumstances may differ, there is no doubt that behind closed doors the monetary policy meetings chaired by President Trichet and Governor King will both be worrying about the same things: the impact of the US recession on exports, the effect on the real economy of the credit crunch, and the incessant rise in food and energy prices. The question is, in what order?