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ECB still on the road to higher rates

Wed, Apr 11 2007, 15:03 GMT
by KBC Market Research Desk

KBC Bank

• ECB to leave rates unchanged at 3.75%
• Strong growth outlook and buoyant money supply growth indicate inflation risks lie still on the upside
• Call for ‘a very close monitoring of all developments’ keeps ECB on track for June rate hike
• Markets look for hints on how high ECB rates may rise this cycle

Following the March rate hike to 3.75%, the ECB governing council is widely expected to leave rates unchanged at its April policy meeting. The tone of the introductory statement and press conference will however be scrutinized to see whether the ECB will continue raising rates beyond the expected 4% in June.

ECB to continue its ‘very close monitoring’

At the last policy meeting in March, the introductory statement underscored the ECB’s intention to raise rates further, even while there were some subtle changes, which suggest that the peak in rates may be coming closer. Indeed, even while Trichet stressed that the ECB will ‘monitor very closely’ all relevant developments and emphasized that ‘acting in a firm and timely manner is warranted’, the fact that monetary policy was no longer considered ‘accommodative’, but ‘on the accommodative side’ and rates were no longer ‘low’, but ‘moderate’ suggests that rates may not have to rise much further.

According to the ECB’s so-called traffic light system (see table below), we expect the ECB to repeat that a ‘very close monitoring of all developments’ is warranted ‘so that risks to price stability over the medium term do not materialise’. This would keep the ECB on track to hike rates at its June meeting to 4%, when the new Eurosystem staff projections will be released. Therefore, Trichet should call for ‘(strong) vigilance’ at the next policy meeting in May.

Above trend growth to fuel inflation

Since the March meeting, the economic indicators have been consistent with ongoing solid growth in the euro area. The EU Commission confidence indicators even rose to a new cycle high in March mainly driven higher by further improvements in consumer and services confidence. As such, euro zone economic growth is expected to remain above trend, which is estimated by the ECB at 2-2.25% for the euro zone economy. According to the ECB staff growth projections, growth will come out at 2.5% Y/Y in 2007 and 2.4% Y/Y in 2008. This supports a continuation of the tightening cycle, as inflationary pressures are expected to rise as long as growth remains above trend. The staff inflation projections showed headline inflation to pick up in 2008 to 2% (slightly above the ECB target) from 1.8% this year.

But pause in tightening cycle coming closer?

The manufacturing PMI however sound a note of caution, as the euro zone manufacturing PMI slowed to its lowest level in 13-months at 55.4. Whilst this is still an elevated level, the moderation of growth in the cyclical industrial sector may have some policy consequences. As mentioned regularly in the past, the ECB’s monetary policy stance has a rather good correlation with the manufacturing PMI survey. In the past, the ECB has raised interest rates only twice when the PMI was below the 55-level. This happened in the beginning of this cycle, when the ECB started raising rates from a historical low level of 2%. Whether the ECB will also continue raising rates in case the PMI would fall below the 55-level is still uncertain, as interest rates are currently at a more neutral level.

It also remains to be seen what the potential negative fallout will be from the recent strong appreciation of the euro and rise in oil prices on business sentiment. The ongoing divergence in economic outlook between the US and the euro zone has pushed the euro above the 2006 highs in the 1.34 zone. A test of the lifetime highs in the 1.36 zone has now become likely. Even while the euro zone economy has become more self-sustaining and the euro trade weighted is still slightly below the 2006 highs, this may incite the ECB to take on a more cautious stance. The oil price on the other hand has had little impact on the economic performance of the euro zone economy in recent years. But if the recent rise in oil prices along with the housing market slump would restrain US consumer spending, the consequences for the US and also the euro zone economy may be much harsher to wear. Our US strategist still believes the US economy will slow further and the Fed will have to cut rates at least two times in second half of the year. Even while this should not prevent the ECB from raising rates further, until now the ECB has never raised interest rates at a time when the Fed was cutting rates. You have to go back to the end of 1991 when the German Bundesbank was responding to a post-unification boom to find an occasion when the ECB’s even tougher predecessor moved in the opposite direction to US rate cuts.

At the same time, the short-term inflation outlook looks still rather favourable, as euro zone headline inflation is still expected to moderate in the coming months, despite the recent rise in oil prices. It will only be in the latter part of the year that the base effect will turn negative and push the inflation rate higher and maybe back above the 2% level. The short-term favourable inflation outlook gives the ECB the room to wait a bit longer to see how the economic cycle turns out before giving further guidance on the rate outlook.

The ECB will also face much tougher opposition to higher rates once rates hit the 4% level. Last week, the president of the employers’ lobby group Business Europe said in the FT that at interest rates above 4%, ‘we are entering another world, there is something there which is very symbolic’. This is not so surprising as we estimate the neutral range in the euro zone between 3.50% and 4%. As such rates above 4% would mean that rates are entering restrictive territory. In that case, politicians and employers will demand hard facts that inflation is running out of hand.

At some point, the ECB will also want to await the impact of the recent tightening cycle on the real economy before raising rates further. Even while the confidence surveys are still upbeat, there are some signs that higher interest rates are starting to bite. While M3 money supply growth is still running at a record pace (10% Y/Y in February), household borrowing is already slowing since April last year from 9.8% to 8% Y/Y in February. Borrowing by nonfinancial corporations on the other hand slowed for the first time this cycle in February from 13.2% to 12.6% Y/Y. In this context, it’s also worth noting that the housing markets in France, Spain and Ireland, which were buoyant until recently, have been cooling lately. In France, the housing starts for example plunged 15.1% in the three months through February, the steepest drop since January 2001.

Markets raise rate hike expectations

Ongoing solid growth along with ample liquidity conditions in the euro zone nevertheless pushed ECB rate hike expectations higher. The Euribor strip curve currently attaches a probability of 60% that rates will rise to 4.25% at the end of the year. Ahead of tomorrow’s ECB meeting, we would not jump the bandwagon anymore, as there are some good reasons why the ECB may consider a pause following the June rate hike to 4%, even while we admit the risks on the upside are building.

Conclusion

At the April policy meeting, the ECB is widely expected to leave rates unchanged at 3.75%. A repetition that the ECB will continue to ‘very close monitor’ all developments would signal that the ECB is still on track to hike rates in June to 4%. Markets will however look for some hints how high rates may rise this cycle. At the moment, a pause following the June rate hike is still a decent possibility, even while the risks on the upside are building.

• Download full ECB still on the road to higher rates

Published on  Wed, Apr 11 2007, 15:09 GMT

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