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Central Banks – On hold for now, but heading down different tracks later

Wed, Jun 4 2008, 05:49 GMT
by HVB Group Global Markets Research

UniCredit Group

• ECB. The European Central Bank should not reveal a trace of an easing bias this coming Thursday either – while a rate cut is totally out of the question: Inflation risks are too great a threat, and the economy remains quite resilient so far. This should also be reflected in the new ECB staff projections (page 2).

• Rate cut. At the turn of 2008/09, however, not even the central bankers in Frankfurt will be able to avoid an initial rate cut. Ultimately, growth will weaken throughout the eurozone, and inflation concerns should subsequently subside again.

• Fed. The easing cycle in the US is, in contrast, over now. The next rate move will be a hike – but not as investors expect already this coming autumn (cf. chart). We do not anticipate the first rate hike before spring 2009 (pages 3-5).

• Bank of England. The BoE is positioning itself between the two: It should lower rates in August, and once again towards the end of the year. That will then mark the end of its cycle, just as the ECB is beginning to cut rates.

• Further topics:

  – France: Housing weakness to weigh on growth, but no economic slump to be expected (page 6).

  – Data outlook: German industry profits from high order backlog; US firms continue to shed jobs (page 7).

  – Market outlook: Government bonds still vulnerable; EUR-USD to stabilize again (page 14).

ECB: Tough talk, no action

• We expect the ECB to leave the refi rate unchanged next Thursday. The decision should be unanimous, despite recent hawkish rhetoric and the acknowledgment that inflation expectations are starting to trend higher.

• We remain convinced that the current policy stance remains appropriate to ensure medium-term price stability. In fact, business surveys point to below-trend GDP growth and core inflation remains in a pretty safe area.

• Eventually, a broad-based cyclical downturn will reduce inflationary pressures and there will be room for a forward- looking policy response. The next move should be a cut, but it will take place no earlier than year-end.

Current policy stance is appropriate

Last month, in commenting on Trichet’s press conference, we stressed (and welcomed in light of our now-aggressive view of a December cut) the fact that Trichet clearly said that no Council member made the case for a rate hike. We expect this to be the case also in June, despite the renewed inflation spike. True, Axel Weber (on May 27), after dismissing any chance for a rate cut in 2008, returned to his April rhetoric and said that the ECB should keep open the option of a rate hike given that inflation would average above 3% this year and there is only a “glimmer of hope” it would return to near 2% in 2009. However, we are confident that this view is isolated within the Council and that quite a large consensus will form on rates on hold for a while – possibly for longer than we envisage – grounded in the belief that the current policy stance remains the most appropriate to guarantee medium-term price stability (Trichet and Papademos on May 25) in the presence of an adverse mix of high headline inflation and cooling growth. Even the departing Liebscher – usually side by side with Weber in the hawkish camp – on May 16 said that the current monetary policy stance was very suitable to maintain price stability and to avoid inflation expectations building up. Indeed, it is inflation expectations that strike a significant difference between the ECB and other major central banks at the current juncture. The ECB is perceived as the only true inflation fighter and it is not a coincidence that in a special report issued for its 10th anniversary, the ECB noted, “signs are emerging that inflation expectations have been trending up recently … to remain credible, monetary policy needs to be constantly alert”.

Growth outlook is worsening

But the economy is slowing – the ECB is fully aware that the first quarter will prove an outlier – credit restrictions keep biting (although official data keep painting an upbeat lending landscape), and, looking at HICP components, the peak in food inflation may not be too distant. The framework remains one of tight financial conditions: we are still dealing with stubbornly high money market rates, wide credit spreads, high oil prices and a strong euro. If the ECB lending survey is of any reliability, then in the next few months lower availability of credit will dampen the investment outlook. Looking through data volatility, GDP momentum is settling below trend, firms’ margins are facing increasing pressures, the investment upswing is set to come to a halt, and the labor market is following suit (probably faster than expected). This is the typical cycle juncture where you should be at least equally worried about the impact of the oil rally on the growth performance and on inflation, even because the real income dynamic is severely affected and, given the large uncertainty, it is unlikely that private consumption will be supported by a lower saving rate. Eventually, a broad-based cyclical downturn will reduce inflationary pressure and conditions for a forward-looking policy response will resume.

Bottom line

At next Thursday’s meeting, the updated Eurosystem projections will probably display higher growth for this year (1.8% vs. 1.7% three months ago), and a mild downward revision for 2009 (1.5-1.6% vs. 1.8% in March). Inflation forecasts for 2008 will likely be lifted from 2.9% to 3.4%, and to 2.2% for 2009 (next year’s number is currently 2.1%). In this context, there is no room to cut rates without triggering a rise in inflation expectations, and jeopardizing the ECB’s hard-won antiinflation credibility. However, rates on hold for longer will worsen the growth outlook. Unlike the ECB, we do not think this is a mid-cycle slowdown, rather the beginning of a genuine and protracted cyclical downturn. We may be faced again with conditions calling for monetary easing sooner than what the ECB thinks.

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Published on  Wed, Jun 4 2008, 05:56 GMT