• Confidence. The Fed still expects inflationary pressure in the US to continue to ease this year, and inflation expectations to remain firmly anchored. Break-even inflation as the difference between traditional and inflation-linked government bonds even declined recently.
  • Risks. But this view of inflation could reverse later this year. The rapid rise in commodity and especially gasoline prices will exert pressure both on inflation and inflation expectations (cf. chart below). In addition, wage pressure is increasing and import prices are rising again.
  • Fed. This will harden the anti-inflation bias of the Fed. The already low probability of a rate cut could give way to speculation on the need for higher key rates in the course of H2.
  • ECB. Inflation risks are also clearly biased to the upside in the eurozone. Rising energy prices, the excess liquidity, tight capacity utilization rates and mounting wage pressure are a concern for the ECB. Our key rate expectation of 4.50% is on even firmer ground .

Further topics:

  • Germany – Why is the upswing so strong.
  • France – Why do we remain optimistic on growth.
  • US – Why the first quarter GDP reading will be revised down.
  • Data outlook: Purchasing managers becoming more confident.
  • Market outlook: Government bonds and EUR remain vulnerable.

CAVEAT EMPTOR!

The latest Monthly Bulletin of the ECB, fresh off the press, strikes a very hawkish note. It states in no uncertain terms that monetary policy remains accommodative. It reaffirms confidence in the mediumterm growth outlook. And it maintains a very clear focus on medium-term inflation prospects, where risks are deemed to be squarely biased to the upside.

The ECB is very up-front in stating that it expects inflation to decelerate in the next few months, reflecting mostly favorable base effects on energy. It also stresses, however, that this will be a short-term development which will have no impact on its policy stance. This is because it expects inflation to rise again after the summer, and to “hover at levels around 2%” toward the end of the year. This is broadly in line with our own current inflation forecasts. Hence, the conclusion, “it is important to look beyond any short-term volatility in inflation rates”.

Medium-term inflation risks stem from a well defined list of what by now we know as the usual suspects:

Capacity utilization, which appears increasingly stretched due to the sustained strong growth performance.

Fast growth of monetary and credit aggregates, although the bulletin notes evidence that interest rate hikes are beginning to have an impact on M1 and loans to the private sector.

Wage dynamics.

The message is very clear. The ECB was the first to have faith in the strength and sustainability of this recovery, and it has been proved right. The ECB also knows that this recovery was built crucially on wage moderation and productivity improvement, supported by a favorable external environment. The ECB does not seem to be convinced, however, that the eurozone’s speed limit has been raised. Structural reforms have not been deep enough so far, and the ECB cannot be sure at this stage that the eurozone’s rate of potential growth has risen. But if potential growth has not risen, then the longer Europe grows at the current pace, the higher the risk of overheating. And as workers are, understandably, keener to reap greater benefits from the economic upswing, there is a risk that wage dynamics could fuel inflation and offset some of the recent gains in competitiveness: In other words, a risk of higher inflation but also of slower economic growth in the years ahead. In the last few days, ECB President Trichet has renewed his appeal to trade unions and employers to exercise responsibility in wage negotiations, i.e. to maintain wage growth at moderate rates. In doing so, Trichet has also referred to the insider-outsider problem of the key European labor markets, stressing that wage moderation for those currently employed is important to help the unemployed to get back into the job market. Analyzing activity and inflation data in the next few months will be especially important in our view. The market has already come a long way towards pricing in our long-standing call of a refi rate peaking at 4.50% by year-end, and the impact on bond yields has clearly been felt (cf chart.)

Opinions on what the medium term holds, however, differ. Some believe growth has peaked and is set to lose steam, and that the ECB is overdoing its policy tightening. This argument implies that we should enter 2008 at a significantly lower growth pace, and with the ECB already pondering the timing of the next rate cut. Others, the ECB included, believe growth will continue at close to the current pace. If that is the case, much will depend on inflation developments. In particular, there is a risk that if inflationary pressures rise, the market might start positioning for a longer monetary tightening cycle. We will monitor the data with strong vigilance (!) and will keep you posted. In the meantime, we fully expect that next month the ECB will not only hike the key rate to 4%, but also reiterate that the monetary policy stance remains accommodative, and will signal quite clearly that there are further rate hikes ahead.