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ECB: Rate Hike Postponed For Now

Fri, Aug 31 2007, 11:46 GMT
by HVB Group Global Markets Research

UniCredit Group

• Underestimated. The Fed has obviously underestimated the impact of the housing market on the economy. It now sees an "appreciable" increase in the downside risks for the economy. Direct and indirect effects of the contracting housing market will continue to slow growth perceptibly (pages 3-5). To prevent the growth motor from stalling, monetary policy easing appears highly likely on September 18.

• Transmission. This is also impacting the monetary policy of other central banks. The tense situation on credit markets as a result of the subprime crisis and the related growth risks should prevent the ECB from tightening next week (page 2). The Bank of Japan also already waived the possibility of a tightening move in August. The situation is similar for the Swiss National Bank and the Bank of England.

• Postponed. Despite the heightened uncertainty and the expected rate hike pause, growth prospects in the eurozone remain solid and indicate, together with the even accelerating money supply growth (pages 6-9), further need for action to keep inflation risks in check. Once normality has returned to financial markets, the ECB will probably resume its tightening cycle as early as the fourth quarter.

• Further topics:
  – Data outlook: US purchasing managers more pessimistic.
  – Market outlook: Inactive money markets remain a burden.

ECB: On hold, for now

Monetary policy in most key countries has now become contingent on financial market developments. This holds for the ECB as well, and we now expect that it will keep rates on hold at its meeting next week.

The ECB’s assessment of Europe’s economic fundamentals does not appear to have changed. Bundesbank President Weber in particular has been very clear in restating his confidence in the robustness of the German economy, and the ECB has reiterated its determination to keep inflation pressures in check. It is obviously too early for the dislocation in financial markets to be reflected in actual economic data— but the ECB realizes very well that a deepening of the financial crisis, and perhaps even a protracted period at these levels of dislocation, would have a negative impact on the economy, as the Fed has already openly acknowledged.

Monetary and financial conditions in the eurozone have tightened since the onset of the crisis, but not substantially. The tightening has been driven mainly by the rise in the Euribor rate, and to a lesser extent by the correction in equity markets, partially offset by some weakening in the euro’s tradeweighted exchange rate and a marginal decline in swap yields. The downward moves in oil prices and long-term interest rates have also softened the impact on monetary and financial conditions.

The key issue, however, is that the marked rise in the Euribor rate reflects a severe malfunctioning of the money market, reflecting fears of a credit crunch. While ECB intervention so far has done a good job in bringing the EONIA strip down to levels close to the refi rate, the Euribor strip (where credit risk is more visible) shows no tendency to adjust downward. Moreover, neither market rates nor our MCI and FCI indices tell the full story. The financial system on both sides of the Atlantic is still partially paralyzed: banks are hoarding liquidity and are not extending credit to each other or to other financial institutions; and it has become extremely difficult to roll over the large amounts of commercial paper coming due. This reflects the banks’ enormous uncertainty about the size and distribution of potential losses in the financial system as a whole, and the consequent extremely risk averse attitude in assessing counterparty risk.

Unless normal functioning of the financial and banking system is restored, there will be an impact on the real economy. Europe is less vulnerable than the US to the direct effect of this financial dislocation: private consumption is less reliant on credit, the corporate sector is profitable and can rely on self-financing for a while, and the European economy still enjoys considerable momentum. Nonetheless, near-paralysis in the financial system will eventually affect consumers and producers in Europe, and, more importantly, the substantial impact on growth that we would witness in the US would inevitably spill over to Europe and the rest of the world.

Against this background, we believe the balance of risks for the ECB leans in favor of keeping rates on hold on September 6. This would not imply an end to the tightening cycle. The ECB will most likely reiterate its bullish view on the growth outlook and its concerns about inflation risks. It will, however, acknowledge the risks to growth posed by the current dislocation in financial markets and argue that it needs more time to monitor and assess market developments. As long as this message is clearly communicated, the credibility of both the ECB’s anti-inflation commitment and its baseline scenario of solid eurozone growth would be preserved. The ECB’s own standing could actually be enhanced if its handling of monetary policy is seen as pragmatic, flexible, and well-attuned to developments in both the real economy and financial markets. The cost of a pause would then be extremely limited, and if normalcy in financial markets is restored quickly enough, the tightening cycle could resume as early as October. On the other hand, hiking rates on September 6 would risk putting additional stress on an already strained and fragile financial system, particularly as the expectation of a hike has now been priced out by the market.

Beyond that, we still believe that the ECB’s tightening bias will remain in place. We do not think that the Fed’s shift to a neutral bias will soften the ECB’s stance; to the contrary, if the Fed’s targeted moves and its apparent willingness to cut the Fed funds rate if needed succeed in stabilizing the financial system, that will make it more likely that the ECB’s own monetary policy will remain on track. The next step for the ECB will be to monitor closely business surveys, lending data and credit standards to determine the extent of the impact of financial market distress on the real economy. This evaluation could require more than just two-three months of data flow, so that chances are that the refi rate peak will be postponed to H1 2008. For the time being, we remain convinced that eurozone fundamentals are strong enough to withstand the turmoil, that any GDP deceleration below trend will be temporary, and that the underlying growth momentum will remain solid for several more quarters.

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Published on  Fri, Aug 31 2007, 11:56 GMT