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Friday Notes

The ECB's hike experiment

Fri, Jun 27 2008, 13:25 GMT
by HVB Group Global Markets Research

HVB Group

• Rate hike. When ECB Council members meet next Thursday in Frankfurt, anything but a refi rate hike by 25 bp to 4.25% would be a major surprise – stirring up markets as was already the case after Trichet's press conference in early June (pages 4-5).

• One-off measure. But we expect that this is not the beginning of a rate hike cycle, although inflation will be flirting with the 4% level in the coming weeks. In fact, the economic slowdown in the eurozone will be more pronounced than is widely expected. The business climate surveys signal "danger ahead", even in Germany whose economy has proved very resilient so far (pages 6-7).

• Easing cycle. For this reason, we continue to think that the ECB can't avoid adopting an accommodative monetary policy, even though it might be spring 2009 before it begins to loosen the policy reins. At that time, the risks to growth will be clear and inflation as well as inflationary expectations will have abated enough for the ECB to start easing.

• Bank of England. We still expect rate cuts also by the BoE. However, in view of the current inflationary pressure, we think that easing moves have been pushed back further to early 2009. In any case, risks of a drastically weakening economy argue against a one-time rate hike à la ECB.

• Further topics:
  

  – Commentary: Fed – neutral with slight hawkish tone (page 2).

  – Germany: Surging energy costs hammer private households (p. 8).

  – US: Banking sector: a new challenge for the Fed? (page 13)

  – Data outlook: EMU inflation to rise again; US purchasing managers to become even more pessimistic (pages 15).

  – Market outlook: Not many impulses for govies or the EUR (p. 22).
  

Fed – A neutral bias with hawkish tinge

The Fed left the benchmark rate on hold at 2% as expected. The statement, however, is visibly more hawkish than at the previous meeting in April – I would characterize it as a neutral bias with clear hawkish tinge. It indicates the Fed will not hike in August, but suggests that if the US economy confirms its resilience in the coming months, the first hike might come sooner rather than later, possibly before year-end. Note also that Fisher dissented in favor of a hike.

The statement is significantly more sanguine on growth, in line with recent statements by Fed officials: “… overall economic activity continues to expand, partly reflecting some firming in household spending …” replaces the old “… economic activity remains weak”. This is a significant upgrade of the Fed’s confidence in the economic outlook. The statement fully acknowledges the persistent downside risks to growth and does not over-emphasize inflation concerns, but it points out that downside risks to growth have diminished, while upside risks to inflation and inflation expectations have increased.

The stream of news and data releases that preceded the FOMC meeting provided a stark reminder that the Fed, like other central banks, faces an extremely complex challenge. Newspaper headlines were dominated by the announcement of significant price increases by some large industrial companies, which argue they have no choice but to pass on to their customers the persistent rise in input costs. The general tone of the analysis and comments was that this is probably just the beginning of the inevitable cascading of higher commodity prices down the distribution chain. At the same time, however, US consumer confidence plunged and house prices dropped further, suggesting that the real economy is not out of the woods yet, and that households will find it hard to accept further increases in consumer prices.

The Fed’s assessment of the balance of risks is sound. The real economy is holding up better that many people feared, and the most recent data point to positive GDP growth also in Q2, after the reassuring surprise of Q1. It seems most likely that the US economy will avoid a recession. Unemployment will rise further, but the increase has so far been moderate and is also consistent with a relatively soft landing. If what we have seen in the first half of the year was the worst, then the Fed should indeed be less concerned about growth, and worry instead about the inflationary risk posed by negative real interest rates.

I think, however, that picture which the data paint is not sufficiently reassuring to open the way for rate hikes. I have argued for some time that the US downturn is going to be less deep than feared but longer lasting than hoped, and I believe the evidence points clearly in this direction. The prompt policy response of monetary and fiscal authorities has cushioned the blow, but it is very difficult to see what might spur a prompt and dynamic recovery from the current slump, especially as the slowdown is now migrating to other regions, thereby worsening the global backdrop. Moreover, downside risks to growth remain considerable, and the risk of a further and sharper growth slowdown cannot be written off yet.

Monetary tightening would therefore reflect stronger inflation fears rather than just greater confidence in growth. Are such fears justified? Core inflation remains well-behaved, and while short-term inflation expectations have risen in line with oil prices, medium-term inflation expectations have remained broadly stable, suggesting confidence that price stability will prevail. If we add to this picture weak growth and rising unemployment, a wage-price spiral seems very unlikely. There are some concerns that the inflation-output trade off has become less favorable, i.e. that the Phillips curve has flattened. This issue has been raised by Fed officials in the past, as a warning that reducing inflation expectations would now require a greater cost in terms of higher unemployment and lost output. The implication would now be that the ongoing rise in unemployment might not be enough to suppress a rise in inflation expectations and wages that might follow the persistent rise in commodity prices.

Inflation expectations are a "recognized" unknown: we all seem to agree that they are essential to price stability, but we do not fully understand how they are formed and how they impact the price-setting process. We all say that anchoring inflation expectations at low levels has been the greatest success of monetary policy in the last few decades, even though it seems somewhat counterintuitive that the main central banks have managed to gain enormous credibility just as they kept monetary policy very loose over the last several years. Have central banks perhaps just been lucky, as the deflationary impact of globalization kept headline inflation low notwithstanding loose monetary conditions, and was reflected in turn in low inflation expectations? It cannot be ruled out, and faced with this uncertainty it is understandable that central banks want to take a cautious approach to try to prevent a rise in inflation expectations.

Commodity prices are the other unknown: we do not really understand what is happening to oil prices, for example. We all agree that some increase is justified by fundamentals, including rising future demand, supply constraints and geopolitical risks. There is a lot of disagreement, however, on whether and to what extent financial factors are contributing to the rise. Central banks like the Fed and the ECB started off by saying, “it is a temporary rise and we are confident it will be reversed”, then moved to, “we believe it is a temporary rise and our forecasts assume it will stop, although uncertainty is high”, and are now saying, “we are not sure anymore that it is a temporary rise, it might actually be a new secular trend, albeit at a somewhat lower pace”. This change of view might be the gradual acknowledgement of a structural change in the global economy, or it might be another example of capitulation in the last phases of a bubble, where even the most hardened skeptics succumb to self doubt. It will take time to find out, but in the meanwhile it seems clear that central banks are less and less willing to bet on an early stabilization of commodity prices, and want to buy some insurance with tough talk and possibly tough actions.

Bottom line: the rise in headline inflation driven by the relentless pressure from commodity prices is making the Fed increasingly uncomfortable with deeply negative real interest rates. If the economy confirms its resilience, the temptation to hike will rise steadily in the coming months. Rate hikes will not come soon, however, as the downside risks to growth are still too significant and will take time to dissipate – but they might come before year-end.

• Download Full Friday Notes

Published on  Fri, Jun 27 2008, 13:35 GMT

Archive

• Inflation: No all-clear yet
  Published On Fri, Aug 22 2008, 13:52 GMT
• Eurozone on the brink of recession
  Published On Thu, Aug 14 2008, 12:37 GMT
• US economy on federal life support
  Published On Fri, Aug 8 2008, 12:17 GMT
• Mounting recession risks in Europe
  Published On Fri, Aug 1 2008, 13:00 GMT
• US labor market – just a mirror image of the growth weakness
  Published On Fri, Jul 25 2008, 12:50 GMT

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