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Fed to start normalizing its monetary

Fri, Jul 4 2008, 13:10 GMT
by HVB Group Global Markets Research

UniCredit Group

• Impulses. Once again, the US economy is proving to be more “resilient“ than anticipated. At just over 1½%, we expect that GDP growth in Q2 2008 was even stronger than at the beginning of this year (+1%). The main catalyst was, however, the federal tax rebate checks (p. 5-7).

• Fed. This boost to purchasing power should also be felt in the current quarter. At the same time, inflationary pressures are still increasing. But the Fed cannot yet scale back its massive monetary policy stimulus as reflected by the negative real target rate (cf. chart): the financial crisis has not been resolved, equity markets remain vulnerable, the labor market is still weakening, and the elections are drawing closer.

• Policy change. The Fed should, however, have reached the turning point towards the end of the year – even though GDP growth will inevitably fall back once federal stimulus has ended. But by then, the US economy should have finally found its floor and is expected to recover in 2009 – albeit slowly but steadily (pages 8-10).

• Diverging. After a first hike in December, we expect the Fed to raise the target rate (currently at 2%) to 3% by mid-2009, and to 3½% at the end of next year. In contrast to that, increasing growth risks in the eurozone should force the ECB to lower its refi rate appreciably in 2009 – even though markets are still betting on a further rise in key rates, despite yesterday’s hike.

• Further topics:
  

  – Weekly Comment: The ECB’s shot in the air (page 2).

  – Germany’s 2009 budget not very ambitious (page 11).

  – Data outlook: Bank of England to leave its repo rate unchanged;import prices to increasingly worry the Fed (page 13).

  – Market outlook: USD and bonds well supported (page 19).

A shot in the air

The ECB raised interest rates by 25bp to 4.25% yesterday, and Trichet proved extremely adroit and effective in communicating a very clear message: yesterday’s hike was a signal to demonstrate unequivocally that the ECB is serious about fulfilling its mandate to deliver price stability. If wage- and price-setters heed the signal, no further hikes will be necessary – but if second round effects should materialize, the ECB will not hesitate to act again. This was a warning shot fired in the air; the next one would be aimed at the legs of the eurozone’s economy, should it prove necessary to stop runaway wages in their tracks. The statement said that “the decision was taken to prevent broadly based second round effects and to counteract the increasing upside risks to price stability”, thereby confirming that this was largely a preemptive move. Trichet yesterday faced the very hard task of persuading markets that further rate hikes could be largely priced out but should not be ruled out – and he succeeded. He also succeeded in largely undoing last month’s damage to the communication policy. The overall tone of the ECB press conference was less hawkish than the market feared, and took some pressure off the EUR and eurozone yields, as investors scaled back their expectations of further tightening. This vindicates our house view that yesterday’s hike will be a one-off, but I would still not underestimate the ECB’s readiness to respond to further unwelcome developments in wages or inflation expectations.

Trichet repeated several times that after yesterday’s decision, the ECB has no bias and believes its monetary policy stance will contribute to achieving its objective of price stability in the medium term. These are two very clear and strong signals that the ECB believes yesterday’s hike might indeed suffice. In response to a question, Trichet also indicated that any change in stance would be communicated to the markets in a clear way, “to be as predictable in the future as we have been in the past” – of course, this is only partially reassuring to the extent that it includes the June episode, but it is nonetheless an important indication of the ECB’s commitment to transparency. Trichet indicated that yesterday’s decision was unanimous, but I suspect divisions within the council still run as deep as they did a month ago.

Trichet also clearly indicated that the ECB’s paramount concern yesterday was to bolster its own credibility in a very difficult environment of rising commodity prices and weakening economic growth. Trichet adopted a grave and statesmanlike tone to say “solemnly” to European citizens that they can count on the ECB to guarantee price stability and keep inflationary expectations anchored. He emphasized that confidence in the central bank is essential, and that price and wage setters should therefore stand reassured that the current bout of high inflation, while prolonged, would be temporary. He stressed that price- and wage-setters should take this to heart, and base their behavior on the assumption that inflation will return to target within the medium-term policy horizon.

Trichet boldly sidestepped or ignored a few key questions, and this I believe was the best way to keep the message focused and clear. He refused (twice) to comment on the idea that ECB tightening could boost oil prices via a weaker dollar – there was no good answer, and he simply reiterated his appreciation for the US’s strong dollar rhetoric. He also refused to say whether the ECB had been surprised by the sharp curve inversion following the June meeting, and whether it was worried about the adverse impact of the inverted curve on the banking sector – again a no-win situation that would have risked muddling the main message. He also declined to comment on whether a single rate hike could really be enough to bring inflation back on track – arguing that it was a carefully calibrated move and that he had already made the point that it should be enough if the signal is taken to heart by economic agents. Overall, this strategy was the best way to undo the damage of the June press conference, and the best way to persuade markets that further hikes should be largely priced out, but not ruled out.

The ECB’s assessment of price developments reiterated that risks remain to the upside, and reported a “very strong concern” that price- and wage-setting behavior could add to inflationary pressure through second round effects (ratcheted up from last month’s “strong concern”). It also repeated that upside risks to price stability have increased further. This is fully in line with the decision to hike, and places even more strongly the emphasis on the risk of second round effects. Note that the section of the statement devoted to price developments brought back more clearly the emphasis on the medium term objective, compared to a month ago: the June statement elaborated on the period over which inflation would hover above 3%; yesterday’s statement by contrast makes reference to the 2% target. In my view, this is aimed at de-emphasizing short-term developments, and is in line with Trichet’s insistence that the ECB will bring inflation back to target (2%) in the medium term (18 months). The message is that as long as economic agents keep the faith in the ECB, the bank will keep the faith in its forecasts, which show inflation declining into 2009. This is in line with our projections: assuming that the commodity price shock will gradually fade away and that slowing growth will keep wages and prices at bay, we forecast a sharp drop in headline inflation to the stable trend of core inflation (cf. chart next page). In this regard, it is important to note that the statement speaks of the ECB’s intent to prevent broad-based second round effects – thereby recognizing that wage and price pressures have so far been episodic and not systemic.

The assessment of the growth outlook sounded slightly more cautious than a month ago. The key change is that the statement recognized that the healthy state of the labor market would not be enough to offset the adverse impact of rising energy and food prices on purchasing power, undermining the outlook for private consumption. The view on investment was sanguine, and Trichet repeated that the financial turmoil does not seem to have constrained credit supply so far – although the statement continues to acknowledge the risks that the financial crisis might have a greater than anticipated impact on the real economy.

The ECB's view on growth is still too optimistic, in my opinion. Yesterday’s hike came on the heels of weak June PMI figures that confirmed the ongoing deceleration in eurozone growth, highlighting that the deterioration is becoming extremely sharp in some countries. Spain’s services PMI fell well below 40, and readings in Italy and France remained weak. The services PMI confirms that the eurozone’s economy is set for a brusque deceleration, which we expect will push y-o-y GDP growth below 1% in the first quarter of next year, setting the stage for a very anemic 2009 (cf. chart next column).

The prospect of decelerating growth was reflected in another very clear message: that a degree of pain and reduction in eurozone living standards is unavoidable: Trichet repeated that we are facing a transfer of resources from commodity importers to commodity producers, and that it would be futile to try and oppose resistance by pressing for wage and price increases – these would only translate into second round effects, with a negative impact on future growth. The transfer of resources to commodity producers is a fact of life at the moment, it implies a relative impoverishment that eurozone consumers and firms need to come to terms with. A brutally frank and clear message, and an important one to convey, in my opinion.

Unprompted remarks by Trichet during the Q&A showed very clear the degree of concern for development in commodity prices. Trichet made a strong explicit call for the correction of various anomalies affecting the functioning of commodity markets: (1) subsidies that artificially reduce prices and boost demand, especially in some emerging markets; (2) resistance to exploration, drilling, and establishment of new refineries, especially in some industrialized countries; (3) the fact that oil supply is controlled by a cartel; and (4) insufficient degrees of transparency and competition in some commodity markets. Monetary policy will do what it needs to do to prevent second round effects, but other measures are needed in support to stop the first round effects.

The press conference vindicates our house view that yesterday’s hike will remain an isolated episode. The market reacted with visible relief to the press conference, with eurozone yields moving lower and the EUR losing some ground against the USD notwithstanding a weak non-farm payrolls release with the US unemployment rate holding at 5.5%. Expectations of further hikes have been scaled back drastically: OIS-based measures indicate a 1/3 chance of a second hike by September, compared to 2/3 before the meeting, and the possibility of a third hike has been more than halved and pushed back to Q3 next year. Moreover, the spread between 2Y Bunds and the Refi has narrowed to just over 20bp. I would not, however, underestimate the ECB’s readiness to move again if second round effects should materialize in a more serious way. I do not believe they will: I think the wage pressures that emerged in the early part of this year are normal for this late stage of the economic cycle, and will fade as growth weakens. Since the last press conference, however, some measures of inflation expectations have increased further: 5Y/5Y swap breakevens have climbed sharply since a month ago, raising also the uncomfortable question of whether the central bank’s emphasis on inflation risks might paradoxically contribute to pushing inflation expectations higher (cf. chart). I believe the way the ECB phrased its message yesterday is much more constructive and convincing, and it should help cool expectations. I also believe that it will take more convincing and diffused evidence of second round effects actually materializing to trigger a second hike. But should inflation expectations and wages start moving up further, hawkish noises will resume and should be taken seriously.

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Published on  Fri, Jul 4 2008, 13:23 GMT