• Home ::
• Fundamental ::
• Analysis Reports ::
• KBC Flash

• Send
• Print
• Add To

KBC Flash

ECB to raise rates to 3.75%

Wed, Mar 7 2007, 14:52 GMT
by KBC Market Research Desk

KBC Bank

• ECB to hike rates 25bp to 3.75% for the seventh time this tightening cycle
• 2008 inflation projections will take centre stage regarding the outlook for interest rates
• Strong growth outlook and buoyant money supply growth will indicate inflation risks lie still on the upside
• Recent financial turmoil unlikely to change ECB interest rate policy
• Central scenario for a further rate hike to 4% by June still in place
• But fears about US/global economic outlook introduce an element of uncertainty

At its March policy meeting, the ECB Governing Council is widely expected to raise rates by 25 basis points to 3.75%. Main attention will however go out to the press conference for some guidance on the outlook for ECB interest rates beyond the March rate hike. In this context, the publication of the new Eurosystem staff projections may play an important role.



 ECB ready to hike rates again


 By re-introducing its vigilance mantra at the February policy meeting, ECB’s president Trichet paved the way for another increase at its next meeting in March. This will be the seventh rate hike this tightening cycle and bring the main refinancing rate to 3.75%. Whether the increase will be followed by more rate hikes will mainly depend on the data, as rates have entered the so-called neutral range in the euro zone, which we see between 3.50% and 4%. As such, the ECB is likely to adopt a similar stance as in December when it promised to ‘monitor very closely’ all developments but stopped short of explicitly hinting at another increase by dropping the phrase that ‘if our assumptions and baseline scenario continue to be confirmed, it will remain warranted to further withdraw monetary accommodation’. Recent solid eco and buoyant money supply data nevertheless suggest the ECB is likely to hold on to its tightening bias even beyond the March rate hike.



 2008 inflation projections take centre stage in new staff projections


 At the February policy meeting, Trichet emphasized the difference between the short-term and medium-term inflation outlook in the euro zone. While inflation in the short-term is not expected to move back above the 2% level, Trichet stressed that the risks on the medium term still lie on the upside. This message is likely to be confirmed in the new Eurosystem staff projections. According to the FT, the new staff projections will show a downward revision of the inflation projections for 2007 from 2% to 1.8-1.9%, but also a slight upward revision of the 2008 inflation projection of 1.9%. The latter may strengthen the case for the ECB to raise rates further to 4% in the course of this year given the ECB’s focus on the medium term outlook. At the same time, the expected upward revision of the growth projections for 2007 and 2008 from respectively 2.2% and 2.3% will underscore the upward inflation risks inherent to the economy, even if the 2008 inflation projection would remain just below 2%. In this context, it’s worth mentioning that the ECB has always pursued a tightening bias as long as the manufacturing PMI stayed above the 55-level, even when the headline inflation rate hovered below the 2% level.



 Money supply growth supports tightening Bias


 The ECB also suggests that the upside risks to price stability are also highlighted by the monetary analysis. Even while recent interest rate rises eased household borrowing, M3 money supply growth is still accelerating and is currently running at a 17-year high. This may still pose some inflationary risks in the medium to longer term given the longterm relationship between money supply growth and inflation. As such, even while higher interest rates may have started to affect the real economy, buoyant money supply growth is still likely to remain a cause for concern for the ECB for a longer period of time. The rather uncertain relationship may however refrain the ECB from giving too much weight to this issue, the more if the economy would start to slow.



 Financial turmoil unlikely to have changed ECB policy


 Recent financial turmoil may make Trichet somewhat more guarded in providing guidance on the outlook for ECB interest rates, but is unlikely to have changed the ECB interest rate policy profoundly. We therefore mainly refer to how Trichet has handled last year’s May/June correction on the financial markets, which was very similar to what we have seen up until now. During the June press conference, Trichet considered the correction ‘as a normal correctional phenomenon’ and added that ‘the re-appreciation of risks in the financial markets in a way also corresponds to a view of the Governing Council’, as the ECB and other central bankers within the G10 think that ‘there has to a certain extent been an underpricing of risks in the global financial markets’. He even added that ‘if this pricing were to increase somewhat, it would perhaps be going in the direction of an improved pricing of risks’. His comments at the latest press conference in February suggests that the view of the Governing Council did not change since, as Trichet again expressed his concern about the ‘under-appreciation of risks’ and reckoned that this is ‘probably a transitory period’ and that we will have ‘over time an increase in the pricing of risks that will be more in line with a good and appropriate assessment of risks at the global level’. As such, the recent financial turmoil may to a certain extent be a welcome development that won’t change the outlook for interest rates profoundly. This view contrasts a bit with the US, where Bernanke already hinted that if the financial turmoil would continue, the Fed may come to the rescue. In the euro zone, such an approach should not be expected in the short term.



 Markets scale back interest rate expectations


 Even while the recent financial turmoil won’t change the ECB policy profoundly, markets have scaled back their interest rates expectations quite significantly in recent weeks and currently attach only a probability of about 40% to a rate hike to 4% by June and 50% by September. This move can be partly explained by the safe haven flows, that usually favour the short end of the curve, but rising fears about the outlook of the US economy and consequently the euro zone economy played a role too. The outlook for the US economy and its potential spill over effects towards the euro zone economy is currently the main risk concerning to our main scenario for another rate hike to 4% by June.



 Conclusion


 At its March policy meeting, the ECB is widely expected to raise rates to 3.75%. Even while further rate moves will be data dependent, we still expect the ECB to hold on to its underlying tightening bias given the upside risks to price stability related to the solid growth outlook and buoyant money supply conditions. Recent financial turmoil may make Trichet somewhat more guarded in providing guidance on the outlook for rates, but is unlikely to have changed the ECB interest rate policy profoundly. A further significant slowing of the US economy is currently the main risk towards our scenario for another rate hike to 4% by June  

• Dowload full KBC Flash

Published on  Wed, Mar 7 2007, 14:58 GMT

Archive

• ECB to downplay decline in headline inflation
  Published On Thu, Sep 4 2008, 07:58 GMT
• FOMC keeps rates unchanged; No sign of imminent start of tightening cycle
  Published On Thu, Jun 26 2008, 07:54 GMT
• ECB threatens July rate rise
  Published On Fri, Jun 6 2008, 14:27 GMT
• A hot inflation summer; can the ECB sweat it out?
  Published On Tue, Jun 3 2008, 07:58 GMT
• ECB: Uncomfortable but unmoved
  Published On Fri, May 9 2008, 09:38 GMT

[ View All ]

• More Reports from this Author
• More Reports from this Contributor

KBC Bank  | Havenlaan 12, 1080 Brussels
http://www.kbc.be/dealingroom | piet.lammens@kbc.be