• We expect the ECB to deliver a first hike in November 2010. This is somewhat later than we have previously communicated (for August 2010).
  • The implementation of the ECB exit strategy is also likely to be slightly more gradual with the ECB keeping full allotment in place at all auctions in Q3.
  • The reasons are fourfold: 1) Sovereign debt problems and fiscal tightening; 2) Weak monetary developments; 3) Disappointing growth; 4) Delayed peak in unemployment.

Not much room for monetary tightening

The ECB is expected to deliver a first hike of the refinancing rate to 1.25% in November 2010. This is somewhat later than the hawkish August 2010 hike we had previously communicated. The implementation of the ECB exit strategy for non-standard measures is also likely to be slightly more gradual with the ECB keeping full allotment at 1% in place for the final six months auction (in March) as well as for the main refinancing operations and the one and three months auctions in all of Q3. Full allotment at the main refinancing operations are projected to be kept in place until end-2010. The reasons are fourfold.

1. The Greek funding problems and the risk of contagion has put the ECB more in a defensive corner. Risk premiums are likely to decline as the market realises that default is not a politically acceptable option in the EMU. The EU politicians are not keen to announce a detailed rescue plan due to the risk of “moral hazard”, but they fear contagion even more and they are not ready to accept that the EMU has some flaws. A rescue plan will eventually materialise if needed. What remains is, however, a strong need to tighten fiscal policy earlier in the cycle than previously anticipated. A number of countries cannot wait with fiscal tightening until 2011, as previously planned. A more aggressive fiscal tightening will limit the room for monetary tightening without risking pushing the economy back into recession.

2. The first hike will be triggered by a wish to “lean against the wind” in order to avoid future bubbles. The ECB is confident that the monetary pillar serves to give an early warning signal. But monetary developments are still subdued and although loans to households are picking up we need to see a sustained rise in loans to non-financial enterprises before the ECB begins to hike. There are no signs of this happening as yet, but as Jean-Claude Trichet has said at several press conferences, it is quite normal for loans to non-financials to improve later in the cycle. We expect a notable improvement during the summer and autumn, which will fit well with a first hike in November.

3. The rebound in growth has been more muted than we anticipated and the Q4 growth figures were a major disappointment. Traditionally the ECB policy has been driven by growth developments (if you can talk about tradition and the ECB) unless inflation is very high (as in July 2008). PMI new orders have historically been a good predictor of the ECB interest rate path. When PMI new orders reach a level of about 57-58 this is normally a hiking signal. PMI new orders are currently at 54.1 and rising. But we had expected it to be even higher by now. Given the unusual large output gap, the ECB might not be in a hurry to hike even when PMI new orders reach levels above 57 (see discussion below).

4. A precondition for the ECB to begin its hiking cycle is that it is confident that growth is becoming more broad-based and sustainable, which will only be the case when unemployment has stabilised. With growth at next to nothing in Q4 the peak in unemployment will be delayed. It may still materialise in H1 10, but we need growth to speed up notably for that to happen. In that respect it is somewhat comforting to see the strong growth in Asia and the US, which combined with the weakening of the euro, can pull Euroland export growth in the coming quarters.