As expected, the European Central Bank on Wednesday announced a 25 basis point rise in its key policy rate to 4.00%.  This increase is the 8^th in a sequence stretching back to December 2005 during which time the ECB’s refinancing rate has doubled from 2.00%.  The increase had been well signalled by the ECB.  So, market attention was focussed on any guidance on the outlook for ECB policy over the remainder of 2007 and into 2008.

What Did Mr. Trichet Say?

ECB President, Jean Claude Trichet, was careful not to say anything that would explicitly point to higher policy rates in coming months but the tone of the press statement and the nature of today’s new ECB economic projections point towards the strong likelihood of another rate rise during the Autumn and the prospect that the threat of further increases will hang over markets and the Eurozone economy through the second half of 2007 and into 2008.

Mr. Trichet continued the long established practice of using codewords to set out the ECB’s position, even though some other ECB officials recently suggested the practice might be coming to an end.  It seems to be getting harder to give a consistent message in this way.  For example, the ECB no longer considers policy rates to be ‘moderate’ but policy is still judged to be ‘on the accommodative side’. 

That said, these awkward developments don’t detract from a clear message that the ECB feels rates may have to rise again and as a result Mr. Trichet trotted out most of the usual warnings.  He indicated that ‘risks to the outlook for price stability remain on the upside in the Governing Councils view’.  He also noted that ‘acting in a firm and timely manner… is warranted’ and that ‘the Governing Council will monitor closely all developments to ensure that risks to price stability over the medium term do not materialise’.  The continuing use of these coded phrases suggests that the ECB expects that rates will have to rise further.

What Does the ECB Expect?

The threat of further rate increase is also suggested by today’s revised ECB projections.  Growth and inflation for 2007 have been revised higher and inflation in 2008 remains at 2 per cent, just above the ECB’s final target of ‘below but close to 2 per cent’.  So, the ECB is suggesting the job is not yet done.  That said, neither the new forecasts nor Mr. Trichet’s delivery suggested that a particularly aggressive course of action is warranted.  In this context, the forecast for economic growth for 2008, perhaps surprisingly, was revised down, albeit marginally from 2.4% to 2.3%.  According to Mr. Trichet, this adjustment reflects the dampening impact of higher oil prices on activity.  The ECB now sees oil prices at USD 69.9 per barrel in 2008 up from it’s previous expectation of USD 63.4 per barrel.  

It also bases it’s projections on an exchange rate that is 2% higher then envisaged in March.  So, this too may weigh on growth next year. Importantly, the new forecast for 2008 is broadly in line with potential or trend Eurozone growth.  So, the ECB the projected pace of growth next year as particularly threatening from an inflation perspective.  Equally tellingly, the ECB did not raise it’s inflation outlook for 2008 on foot of the rise in oil prices.  Presumably, this reflects the dampening impact of higher borrowing costs and a stronger exchange rate.  So, relative to market expectations, today’s new ECB projections are marginally less threatening to the interest rate outlook than might have been envisaged although they still point to the prospect of an Autumn rate rise.  Technically, the ECB projection assumption of an average 3 month money rate for 2008 of 4.5% prices in about a 50% probability of a second ECB tightening.

If the ECB is likely to raise rates further, Mr. Trichet created a little more uncertainty about the precise timing of further increases.  First of all, the opening press statement suggests the ECB ‘will monitor closely all developments’.  This appears marginally less threatening in terms of timing than the wording that followed the previous rate rise in March which noted that the ECB would ‘monitor very closely all developments’.  The possibility that the ECB wants more leeway about future policy changes was also suggested by Mr. Trichet’s pointed response to a question on current market expectations of a September rate rise.  Mr. Trichet stopped a long way short of endorsing the market view by simply replying that the ECB never pre-commits.  Previously, similar questions were frequently met by answers that indicated the ECB did not want to alter market expectations.  So, today’s response suggests that while September 6^th may still be the most likely date for a further ECB tightening, the precise timing and extent of future actions have become more data dependent.  At present, the ECB expects growth to remain sufficiently robust and inflation risks to persist in a manner that will require further policy action but the fact that the timing of future rate hikes has become more fluid means that the ECB does not envisage taking a particularly aggressive stance in the foreseeable future.

Why Have Rates Risen So Far And So Fast?

It may be worth putting Wednesday's ECB rate rise into context.  When the European Central Bank began raising rates in December 2005 few if any analysts expected that rates would rise as far or as fast as has been the case.  Indeed, the expectations of the futures market nineteen months ago was that policy rates would now be just below 3 per cent.  In large part, the speedier and sharper tightening in the interim reflects a dramatic change in the growth performance of the Euro area of late.  Between 2002 and 2005 Euro area GDP growth averaged just 1.3%.  After recording growth of 2.7% in 2006, the ECB now sees growth in 2007 of 2.6% and 2.3% in 2008. 

As Diagram 1 suggests, the recent improvement in Euro zone growth is particularly impressive relative to the experience of the US although it could be argued that this in part reflects a catch up from the relatively disappointing experience of the 2002-2005 period.  Again, the Diagram hints at a similar ‘late cycle’ catch up in 1999.  In that episode, the catalyst was the advent of EMU.  Of late, the main driver has been the dramatic improvement in the fortunes of the German economy.  Reflecting the sharply changed growth dynamic in the past year, we and most other forecasters, have been forced to repeatedly alter our expectations for ECB policy rates. 

How Much More Tightening is Needed?

Two key questions now emerge.  The first is whether expectations for the persistence of very strong growth through 2007 and into 2008 will prove correct.  The second is how much additional ECB tightening might be required to ensure inflation remains under control.

According to yesterday’s ECB statement, the longer term risks to the economic outlook remain on the downside.  This view is shared by the IMF which, earlier this week, suggested ‘the risks to this outlook are relatively small and on the upside in the short run, but wider and shift to the downside further out.’  In this context, the IMF suggested that ‘external risks are to the downside and growing over time’ and relate to a range of factors from high oil prices to sluggish US growth.  While the IMF saw domestic risks towards the upside and dominating in the near term, it noted that ‘over the medium run, however, stretched housing markets in some parts of the area raise some domestic concerns’.  So, while the near term outlook for activity in the Eurozone remains strongly supportive of further tightening, the speed and scale of future increases will increasingly be tempered by greater uncertainty about the persistence of strong growth through 2008 and beyond. 

A related but distinct issue is how much further policy rates might need to rise to restrain growth sufficiently to ensure inflation doesn’t accelerate.  In this regard, two key considerations are the extent of inflationary pressures in the Euro zone at present and the extent of the time delay before the sequence of interest rate increases implemented since December 2005 really begins to bite.  In regard to the former, Mr. Trichet once again signalled yesterday that increasing capacity constraints represent upside risks to the inflation outlook.  However, as Diagram 2A indicates, the relationship between capacity usage and inflation has been far from clear-cut in the past 10 years. 

Meanwhile, Diagram 2B suggests that in recent months price expectations among consumers and manufacturers have drifted lower, presumably as fears related to the impact of the hike in German VAT have faded.  While it would seem reasonable for the ECB to err on the side of caution in terms of its policy settings, the limited evidence of strongly evident price pressures in those indicators would caution against overkill.  As we have noted previously, the ECB is acting against the risk rather than the reality of higher inflation.  So, it doesn’t need to be particularly aggressive.

A second consideration important in relation to future rate decisions is the time it takes for interest rate changes to feed through to activity and inflation.  The ECB website sets out various econometric model-based estimates of the impact of interest rate changes.  On the basis of the average of these models of the Eurozone economy, each 1 percentage point change in policy interest rates alters GDP growth by 0.3 per cent in the first year and by 0.5 per cent in the second year.  This results in an impact on inflation of just 0.1 per cent in year 1, 0.2 per cent in year 2, 0.3 per cent in year 3 and 0.4 per cent in year 4.  So, these models suggest it takes some considerable time for the full impact of policy changes to feed through activity and inflation.  Judged from this perspective, it might be suggested that the doubling of ECB policy rates since December 2005 will only be significantly felt in late 2007 and into 2008, particularly as 150 basis points of this increase has come in the past twelve months. 

Already there are clear signs that the impact of higher rates is beginning to be felt in an easing in borrowing growth.  As Diagram 3 indicates, borrowing growth by households has been softening since April 2006, borrowing by non-financial companies has slowed in 2007 and, if we adjust money supply data for the influence of transactions outside the Eurozone, we find a clear easing in underlying money growth has been evident since September 2006.  In the light of the orderly slowdown already evident in these data in late 2006/early 2007, the ECB might anticipate both a further significant easing in borrowing growth and clearer evidence of the restraining influence of higher borrowing costs on activity and inflation will become evident in the next six to twelve months, with a more forceful impact likely to take a little longer to materialise.

What Sort Of Impact Have Rate Hikes Had On The Irish Economy?

There is little doubt that the larger and longer sequence of interest rate hikes has begun to influence Irish borrowers in common with their counterparts across the Eurozone.  As Diagram 4 indicates, the extent of the slowdown in borrowing for house purchase is broadly proportionate here and elsewhere although the pace of borrowing in Ireland remains a good deal stronger than the Eurozone average. 

For someone taking out an average mortgage of around €250K in late 2005, average monthly repayments will have been boosted by 8 ECB rate increases which cumulatively amount to about €280 extra per month in loan repayments.  Over the same time period, a two income family earning €80K per annum will have benefited from income tax cuts and an increase in mortgage tax relief that would have raised monthly post-tax income by about €380 per month.  So, higher borrowing costs have eroded the large part of any gains in spending power in the past two years.  Not surprisingly, this hit to spending power has caused a softening in demand for housing both by first time buyers and by those considering trading up.  Uncertainty about stamp duty has further tempered demand.  As a result, both anecdotal evidence and the indications coming from lending data and tax revenues point towards a particularly soft Spring for the Irish housing market.  However, the metrics outlined above don’t suggest the sort of massive adjustment to household spending that would prompt a significant downgrading of the outlook for the Irish economy as a whole.

Much the same conclusions are suggested by looking at aggregate data.  Irish household borrowing is in the region of €155 bio at present.  With roughly 55 per cent of borrowing at variable rates, this suggests that each quarter per cent rate increase costs household borrowers around €330 mio.  However, personal savers benefit to the tune of around €180 mio.  This means that the net cost of the ECB tightening implemented since December 2005 amounts to around €1200 mio.  Reflecting the fact that borrowers have a greater tendency to spend then savers, this implies that ECB rate increases on the household sector have dampened Irish GNP growth by just under one percentage point.  Taking into account the impact on corporate Ireland (in part through the exchange rate although offset in part by stronger global growth), in very rough terms we are probably looking at an economy-wide effect of between 1 and 1½ percentage points from higher interest rates.  This result compares with an estimated impact of around 1 percentage point for the Eurozone economy as a whole.  Reflecting this (and a variety of other influences), most forecasters now see Irish economic growth in a 4-5 per cent range in 2007 and 2008, around a percentage point or more lower than might have been envisaged twelve months ago (when ECB rates were just about to rise from 2.5% to 2.75%).