As expected the ECB raised official interest rates by 25 basis points today to 3.5%, the sixth increase since last December.  The tone of the ECB press statement following the rate announcement carried a strong warning that policy rates would rise again in early 2007 but it stopped some distance short of making a Spring rate rise inevitable. 

The threat of even higher rates was evident in a number of pronouncements by Mr. Trichet. The ECB sees economic growth remaining strong in the next couple of years although it did acknowledge risks are weighted towards the downside.  He also said that inflation risks remain to the upside although ECB projections show it falling below 2 per cent in 2008.  Mr. Trichet also suggested that interest rates remain ‘low’ and ‘accommodative’ although the press statement pointedly excluded the phrase that ‘it will remain warranted to further withdraw monetary accommodation’ that has featured in previous statements.  So, in summary, Mr. Trichet is suggesting the ECB is moving towards a further interest rate rise in early 2007 but such an outcome is not yet automatic.  This may hint at some split in thinking on the governing council.

We think the ECB is becoming somewhat less clear-cut in its pronouncements as the caveats added to each of the concerns in the paragraph above illustrates.  In part, this reflects increased uncertainty about the economic outlook.  For our money it also hints that the end of the rate hiking cycle may not be too far away.  But it also suggests some confusion in the way the ECB communicates with financial markets which is very evident from a couple of other elements of today’s press statement and conference.  First of all, markets were rattled by a phrase in the introductory paragraph of the ECB statement.  On previous occasions the ECB has used the phrase ‘monitor very closely’ to alert markets to the prospect of a rate hike in two months time. 

When this unexpectedly appeared in today’s statement, traders moved to price in a further rate hike in early February.  However, in response to a question, ECB president Trichet indicated that this was not the correct interpretation.  Having relied heavily on the use of keywords to signal it’s intentions in the past, to suddenly decide that words now mean whatever the ECB wants them to is to behave like the characters in Alice in Wonderland.  In the absence of the broader and deeper discussion of policy offered by the Federal Reserve and the Bank of England, financial markets will continue to rely, in the words of Bank of England Governor Mervyn King, on ‘textual deconstruction’ of ECB statements.  If the ECB wants a little more ‘wriggle room’ on future policy, there must be a better way of achieving this than by arbitrarily changing the meaning of the language it uses.

We were also struck by another apparent contradiction in today’s press conference.  Mr. Trichet appeared to downplay the significance of inflation dropping below 2 per cent in 2008 by suggesting ‘it largely reflected the assumption of lower energy prices’.  However, the ECB’s projections also incorporate an upside bias to inflation from their assumption of some pass-through to inflation from previous energy cost increases as well as the possibility of some pick up in wage settlements.  Neither is it consistent to dismiss the significance of falling energy prices on the inflation outlook when the ECB previously went to considerable effort to emphasize headline rather than ‘core’ inflation.  If the ECB is consistent, falling energy prices should lessen the extent of policy tightening needed.

While we think some elements of the message coming from the ECB may be confusing and possibly contradictory there is little doubt in relation to the intent.  We expect the ECB is likely to raise rates again in early 2007 unless there is a surge in the Euro on FX markets or widespread signs of a dramatic weakening in the global economy.  We think for reasons set out below that 3.75% should be the peak of the rate cycle.

Does the ECB really need to raise rates further?

For some time we have argued that the 2007 interest rate outlook should not be particularly threatening.  This reflects a range of factors.  We think Euro area growth is set to peak (on a year on year basis) in late 2006 and will moderate significantly during next year.  Softer growth in the US economy and the strength of the Euro we feel export growth.  We think the looming VAT rise in Germany will curtail German domestic spending somewhat although it appears that the underlying trend in the German economy is still one of improvement.  However, we reckon the likely loss of momentum in Germany will serve to highlight structural problems relating to the economies of Italy and Spain.  We also reckon French economic performance could underwhelm.  Against this backdrop, we feel the strong impetus to activity in the Eurozone in recent months is unlikely to be sustained through 2007.

The tightening in monetary conditions coming from a sequence of rate hikes and a stronger exchange rate will also dampen activity.  Since December 6 2005, ECB policy rates have risen by 150 basis points and the trade weighted value of the Euro has risen by 5.1 per cent.  On a rough rule of thumb, the impact of a stronger exchange rate is the equivalent of an extra 65 basis points of rate hikes in the past year.  This represents quite a substantial amount of tightening.  To put it in context, the ECB’s previous tightening cycle between November 1999 and October 2000 raised policy rates by 225 basis points but this was offset to a fall in the exchange rate of around 11 per cent, which on our estimates, was the equivalent of rate cuts of around 140 basis points. 

Of course, these sort of calculations are merely illustrative but they suggest that the ECB has tightened policy a good deal more in the past year than in the earlier cycle.  Diagram 1 suggests the extent of ECB action in the previous rate hiking cycle might have been influenced by concerns about a collapsing Euro.  Diagram 1 also suggests the ECB adopted a relatively cautious pace of tightening in the early part of 2006, coincidentally at a time when the exchange rate was rising.  It stepped up the pace of interest rate increases in the second half of 2006 because of markedly stronger Euro area economic growth.  Until very recently this recent acceleration in rate hikes had little impact on the Euro exchange rate.  However, if the Euro were to continue to rise as sharply at anything approaching the near 2 per cent rise seen since the November policy meeting, the ECB might become more cautious.

On our reckoning, the current ECB rate cycle is more aggressive than its predecessor.  On the evidence of Diagram 2, it is not clear that a notably tougher stance is warranted.  As the diagram shows, economic growth peaked above 4 per cent and inflation at around 3 per cent in early 2001.  So, both growth and inflation are less threatening now, from an ECB perspective, than they were in the earlier rate cycle.  So, policy need not tighten aggressively in 2007.

We think the most interesting aspect of Diagram 2 is that it shows economic circumstances can change quite rapidly.  It also suggests interest rate policy acts with a clear and reasonably short lag.  Both economic growth and lending growth to the private sector peaked in the Spring of 2000, roughly six months after the ECB began raising rates.  The ECB continued to raise interest rates for another six months with the final hike coming in October 2000.  As Diagram 2 illustrates, sharply weaker growth in the US and the lagged effects of earlier interest rate increases prompted a marked slowdown in economic growth and a similar turnaround in credit growth. Both tumbled through 2000 and further weakened through 2001 before the final blow from the terrorist attacks of 9/11 pushed growth and lending to exceptionally weak levels during 2002.  We don’t envisage shocks on anything like the scale that caused the downturn in 2001/2002.  However, the ECB’s acknowledgement that longer term risks are to the downside also argues against a particularly aggressive approach to interest rate policy in 2007.

The ECB and the Irish housing market – Can both prosper?

Today’s ECB rate rise will take some of the gloss off Mr. Cowen’s budget largesse.  We reckon that each ECB rate increase takes about €300 million out of the pockets of Irish borrowers in a full year.  Judged from this perspective, yesterday’s increase in mortgage interest relief, which the Dept of Finance estimates will cost €70 mio in a full year, might seem woefully inadequate.  However, this comparison is not the right one to make.  We think two other measures provide a truer measure of how recent and good/bad news may balance in terms of the Irish housing market in 2007.

Set against roughly €1800 mio drained from the pockets of personal borrowers should be noted the substantial tax concessions seen in both Budget 2006 and Budget 2007 which amount to some €2.1 bio.  In terms of economy-wide effects it should also be remembered that Irish personal savers will benefit to the tune of almost €900 mio although their spending propensity may be somewhat lower than that of borrowers.

We think the Irish economy has sufficient forward momentum in terms of activity and employment to underpin the housing market in 2007 thanks to the additional support offered by Mr. Cowen.  Importantly, the changes to mortgage interest rate relief are concentrated in their impact on relatively large borrowers.  From the standpoint of a borrower with a €300K mortgage , the six ECB interest rate increases seen to date will cost around €3000 in a full year (6 rate increases x €42 per month increase in loan repayments x 12 months).  Set against this is roughly €1300 resulting from increased interest mortgage relief for a double income family unit.  Importantly, this relief will rise further if borrowing costs continue to increase.  In addition the typical borrowing couple on a combined salary of around €80-€100K will benefit from tax concessions to the tune of roughly €1500 or more depending on their particular circumstances.  So, Mr. Cowen has directly offset about 40 per cent of the impact of higher interest rate costs and is also providing a significant boost to household spending power.  In these circumstances, we expect the Irish housing market will see decent, albeit single digit, increases in property prices in the coming year.