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ECB: Cautious hints at further tightening

Thu, Dec 7 2006, 15:35 GMT
by Niels-Henrik Bjørn

Danske Bank A/S

Overview

The ECB raised, as expected, its leading interest rate by 25bp to 3.5%. This is the sixth rate rise since the ECB began its tightening cycle in December last year. The rise brings the leading rate into what we suspect is a neutral range of 3.5-4.0%. We also believe that the total financing conditions are now broadly neutral given that low long bond yields probably off set the effect from the stronger euro. On the press conference, Trichet gave the impression that the ECB still leaned towards further tightening of policy although he for the first time since this summer left out any promises regarding future policy tightening. Thus, Trichet con-firmed our expectations, see our preview on the meeting also available at our website.

Details

At the press conference Trichet turned more dovish in four areas:

1. Trichet left out the sentence that “further monetary withdrawal will be warranted”
2. ECB now sees “upside” risks to price stability - not “clear” upside risks to price stability
3. Inflation forecasts were lowered significantly to 2.0% in 2007 from 2.4%. 2008 forecast below 2% at 1.9%
4. ECB sees downside risks to growth

Trichet turned more hawkish in two areas:

1. Notes that domestic growth is dynamic - earlier it was called solid
2. Growth forecasts were revised somewhat up and are generally a little above trend growth

All in all Trichet is scaling down the extent of the pre-commitment to further hikes. Furthermore, the inflationary risks now seem to be more tolerable. Finally, Trichet notes primarily downside risks to growth. Thus, Trichet is softening, but he is still hawkish as he repeats that monetary accommodation is still in place and that there are still many risks to price stability. I believe that the message Trichet wants to put through is that the ECB may have a little more tightening to do before they are finished.

Outlook

We see no reason to alter our expectations of one further rate rise in March 2007 before ECB pausing and possibly delivering one second rate hike late 2007 or at the beginning of 2008.

Financial comments:

• Fixed income markets
  Trichet's hawkishness was in line with our expectations. Rates in the front of the Euribor curve has risen as the market has come to attach a greater probability to a hike in Q1 next year. We maintain our view that the Euribor curve can see further inversion from Jun07 and onwards.

• FX markets
  The rise in EUR/USD from the second half of November probably owed more to concerns over the economic outlook for the US than to strength in Euroland. However, the euro has drawn solid support from a resislient economy as well as the most hawkish central bank in G3. Today's statement from the ECB points to further rate increases in the coming months, which - seen in a context of a Fed on hold and a BOJ in doubt - will continue to provide support to EUR. However, the ECB also seemed to back dawn ever so slightly on the need for additional restraint, particularly during the Q&A session, and markets may no be entirely convinced of rate hikes during - or beyond - Q1. Further trends in EUR/USD thus depends crucially on developments in the US. Technically, we see a correction down towards 1.3130 before the upward trend to-wards 1.3450 - 1.35 resumes.

• Download full Cautious hints at further tightening

Published on  Thu, Dec 7 2006, 15:38 GMT

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