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Friday Notes

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No rash rate hikes

Fri, Jun 12 2009, 12:52 GMT
by UniCredit Research

UniCredit Group

• Stress. In the last two weeks, 30Y US mortgage rates have jumped about 75 basis points. The primary catalyst was a renewed upturn in inflation expectations. A continuation of this development would jeopardize the signs of gradual stabilization in the US housing market (pages 3-7).

• Speculation. In conjunction with the better-than-expected non-farm payroll figure last week, investors are already pricing in rate hikes by the Federal Reserve. The probability of tightening by the end of 2009 is currently more than 60% as indicated by Fed funds futures (see chart).

• Exaggeration. We think this is excessive, and we do not expect rate hikes until next year. The Federal Reserve will certainly want to play it safe. A premature reversal in monetary policy would jeopardize the recovery on financial markets and in the economy.

• Timetable. Instead, the US central bank will eventually have to dial up its rhetoric. There will probably be a stronger emphasis on timely action against inflation dangers. Furthermore, the Federal Reserve will soon make a transition to the verbal steering of investors’ interest rate expectations ("expectation management").

• Further topics:

  – Weekly Comment: Throwing precaution to the wind (page 2).
  

  – Switzerland: SNB will renew its commitment to unconventional measures at its meeting next week (pages 7-8).

  – Data outlook: ZEW still in the updraft. Pessimism in the US housing market to abate (from page 9 on).
  
  – Market outlook: No trend reversal in Bunds. The positive mood should still affect G-10 currencies (from page 16 on).

Throwing precaution to the wind

ECB Governing Council member Axel Weber may have been floating a trial balloon on Wednesday as he argued that precautionary rate hikes may be appropriate to prevent bubbles even when they are not justified by the inflation outlook. He acknowledged such a move would pose a “communication challenge”, but one that could be overcome—and the ECB has certainly not shied away from communication challenges in the past. My view is that this is a valuable lesson to draw from the crisis, but one that is likely to remain irrelevant over the policy relevant horizon. With deleveraging still in full swing, we are far from the point where we can again worry about asset bubbles. And meanwhile, although we do believe that the economy has turned the corner, our analysis finds precious little evidence of upside risks to either growth or inflation. The need to devise an exit strategy is much more pressing on fiscal policy, as the rise in longterm bond yields attests, and the ECB should be wary of the risk that a premature tightening of monetary policy might undermine both the recovery and fiscal consolidation. Mr. Weber’s speech, meanwhile, will likely confirm the impression that the ECB might have more of an itchy trigger finger than the Fed—another upside risk to EUR-USD.

ECB Governing Council member Axel Weber said that precautionary rate hikes can sometimes be appropriate even if they are not justified by medium-term price developments. In a speech in Frankfurt, he argued that when faced with fast money and credit growth and narrowing risk premia, central banks might be well advised to tighten monetary policy in order to prevent the emergence of asset price bubbles. Such leaning against the wind would help guarantee macroeconomic stability in the medium and long term. Taken at face value, this is absolutely correct—indeed one of the main lessons of the crisis is that central banks cannot afford to ignore asset prices and focus exclusively on narrowly defined price stability. The timing of Mr. Weber’s statement, however, seems also highly significant, coming just as signs of economic stabilization have brought to the fore the issue of an exit strategy from policy stimulus. Recently released April industrial production figures, including a healthy rebound in Italy broadly, confirmed that the European economy is turning the corner, with hard data following the stabilization of sentiment indicators. At last week’s press conference, ECB President Trichet attracted some criticism for stating that policy rates were “appropriate” even as the ECB staff’s projections see inflation well below target for the next 18 months. Mr. Weber might have decided to go a step further and float a trial balloon to see how markets would react to the possibility of the ECB hiking rates even before their inflation projections start signaling the need for tightening. The ECB was quick to clarify that the comments did not refer to current monetary policy, and Mr. Weber himself reiterated that the current level of interest rates remains appropriate. However, his comments do seem to echo recent statements by German Chancellor Angela Merkel, who warned last week that central banks might be sowing the seeds of the next bubble, and criticized the ECB for bowing to international pressure with its decision to launch purchases of covered bonds. In this light, I would raise the following three considerations. First, it seems extremely premature to worry that expansionary monetary policy might trigger another credit bubble. Deleveraging is still in full swing, and will cause a prolonged slowdown in credit growth and consolidation in the financial sector. The expansion of central banks’ balance sheets is still only partially compensating for the collapse in the money multiplier. While risk appetite has been recently resuscitated, and commodity prices have begun to react to a more upbeat growth outlook, I see no evidence that we are close to the point where expansionary monetary policy might cause another asset bubble. Second, devising an exit strategy is more urgent for fiscal policy than for monetary policy. The sustained upward movement we have witnessed in long-term bond yields reflects in my view primarily supply and fiscal sustainability concerns. In fact, loose fiscal policy probably poses a more serious risk to inflation expectations than monetary policy at this stage. The ECB should consider the risk that a premature monetary tightening might jeopardize both the economic recovery and the prospects for fiscal consolidation. Third, it will take time before the macro outlook justifies a tightening of monetary policy. We have taken a very constructive view of the so-called “green shoots”, and argued in recent analysis that the global economy has indeed turned the corner. At the same time, however, our hopeful search for evidence of upside risks has so far been in vain. In two analytical chapters of the Euro Compass published this week, we have addressed the question of whether we are underestimating upside risks on growth or on inflation. For growth, the answer is “most likely not”, even though it is encouraging that asking the question seems now justified. As for inflation, in the words of my colleagues Chiara Corsa and Marco Valli, “a liquidity-driven inflation threat, in the eurozone or any other industrialized country, is not on the radar screen.” We still see policy rates on hold for at least another twelve months, in the eurozone as in the US. However, Mr. Weber’s speech signals that the debate within the ECB’s GC remains lively, with the hawks determined to lean against the wind of the current expansionary stance.

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Published on  Fri, Jun 12 2009, 13:02 GMT