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More favourable euro zone inflation outlook unlikely to withhold the ECB from raising rates further

Mon, Jan 29 2007, 17:39 GMT
by KBC Market Research Desk

KBC Bank

• Euro zone headline inflation unlikely to move above 2%, as drop in oil prices offsets German VAT increase
• ECB staff projections for inflation likely to be revised down, but growth up
• ECB to stress growth outlook/excess liquidity to explain the case for higher rates
• Still two more rate hikes expected this year

Until recently, euro zone headline inflation was widely expected to rise back above the 2% target in the beginning of 2007 largely due to the German VAT increase. The risk of an associated rise in wage demands and some deterioration in inflation expectations was seen underpinning further tightening in policy by the European Central Bank. However, a couple of recent developments appear to have made the immediate inflation outlook somewhat less threatening. In turn this has implications for Eurozone interest rate outlooks.

German VAT to push inflation higher, but…

Initial fears about a likely acceleration in inflation in early 2007 were centred on sharply higher indirect taxes in Germany. On the 1st of January, Germany increased its VAT by 3pp from 16% to 19%. This will have a considerable impact on the inflation data for Germany and also the euro zone. The German VAT increase was expected to add 0.3-0.4pp to euro zone headline inflation. All other factors constant, this would cause euro zone headline inflation to rise from 1.9% Y/Y in December to 2.2-2.3% Y/Y in January.

However, in recent months there were signs that some of the VAT increase had already been passed through in late 2006. It may also be expected that not all of the increase will be passed through in January, but that some of the increase will only become visible in February or even March. The discounting of old stock in post Christmas sales meant that some retailers might delay implementing the increase until new 2007 ranges of goods are put on the shelves in February or even March. These timing issues are compounded by indications that some retailers and suppliers are being forced to absorb the tax increase rather than pass it on to customers. So, while regulated prices will mechanically reflect the tax hike, sluggish retail sales mean the final impact of the tax increase may have less of an impact on inflation than initially feared.

Plunging oil prices offsetting factor

At the same time, the recent drop in oil prices as well as a favourable base effect will have a large downward impact on euro zone inflation. Last year, energy prices rose a very strong 2.4% M/M in January, which will now fall out of the calculations. According to the ECB, the favourable base effect is expected to reduce the annual inflation rate by 0.4pp from January to July 2007. In stark contrast to last year, oil prices have plunged by more than 10% in euro terms between December 2006 and January 2007. This is likely to reduce annual inflation by a further 0.1-0.2pp although this impact may take several months to feed through fully to consumer prices.

Taking into account these factors, this suggests some downward risk to the current inflation consensus for January of 2.1% Y/Y. More fundamentally, it suggests that the inflation outlook in the first half of the year will be far less worrying than first thought, which may also have its implications for ECB monetary policy/strategy going forward.

ECB to revise inflation forecast lower, but growth higher

In December, the latest ECB staff inflation projections were revised down rather significantly and showed inflation likely to come out at 2% in 2007 and even slightly below 2% in 2008, which would be in line with the ECB’s definition for price stability. In the next staff projections, which will be published in March, inflation could be revised down further making it somewhat more difficult for the ECB to continue raising rates, even at a slower pace. However, recent ECB comments suggest that the drop in oil prices as well as some better US eco data have also improved the euro zone economic outlook. Today, ECB’s Liebscher hinted at an upward revision of the growth projections by saying that ‘he is more optimistic on the euro zone economy now than in December’. An upward revision of the growth projections will push euro zone growth clearly above potential, which is usually seen at around 2%. This will keep the ECB eager to bring rates somewhat higher in what we consider as the zone of neutral rates between 3.50% and 4%. The Survey of Professional Forecasters, which will be published in the February monthly bulletin may provide a first idea of where the new ECB projections may come out.

ECB talk to shift towards growth

The more favourable inflation outlook may thus require a shift in communication by the ECB. Until now, the ECB has always stressed the importance of the headline inflation number and has argued that the core inflation rate is likely to follow changes in the headline inflation rate over time.

Instead, the headline inflation rate has fallen of late, while the core inflation rate has barely moved. So the underlying inflation picture has not been as threatening as the ECB might have expected. But it must be emphasized that this more favourable outcome has not materially altered ECB thinking on the need for further increases in interest rates. As such, we expect the ECB to put more stress on the growth outlook to explain the case for higher rates. The first signs of this are already evident, as ECB’s Bini Smaghi last week said that ‘if growth expectations are confirmed, the ECB needs to raise rates more to avoid excess liquidity’. ECB Governing Council members still describe monetary policy as ‘accommodative’ or even ‘very accommodative’. As long as the growth outlook remains strong, the ECB will continue to question whether rates should still be accommodative, even though the immediate inflation threat has lessened.

Money supply growth keeps ECB alert

This argument is closely linked to the monetary pillar of the ECB monetary policy concept, as the ECB fears that ‘ample liquidity’ conditions in the euro zone will pose an upside risk to inflation in the medium to longer term. Solely based on monetary indicators the ECB in June of last year projected euro zone headline inflation to remain above the 2% until 2009. As since then monetary indicators have remained buoyant, upward inflation risks stemming from money supply growth have not lessened but have increased further.

In these circumstances, the ECB is likely to take little comfort from the favourable inflation outlook for the first half of the year and will continue to stress upside risks on inflation related to the strong growth outlook and buoyant money supply growth. From the second half of the year, the base effect from oil prices will turn unfavourable and is expected to add around 0.5pp to euro zone headline inflation from August to November 2007. As such, as long as the growth outlook remains strong, one may still expect the ECB to raise rates more than the widely expected hike in March.

Inflation expectations ignore fall oil prices

Importantly, in this context, it’s also worth noting that financial market’s inflation expectations have also taken little comfort from the drop in oil prices, as inflation expectations did not track the drop in oil prices, but remained rather sideways oriented around the 2.15% level in line with price stability.

Conclusion: two more rate hikes still likely

In conclusion, the more favourable than expected inflation outlook for the first half of 2007 is unlikely to change the interest rate outlook of the ECB profoundly, but may require a shift in communication putting more importance on the growth outlook. As long as growth remains strong, two more rate hikes are still expected this year. In this sense policy is somewhat more data dependent. In the months ahead, growth data will hold the key to when and at what level the ECB feel they can ‘pause’ in the tightening cycle.

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Published on  Mon, Jan 29 2007, 17:47 GMT