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| Jan - Sept 2007: Euribor 3-Month Rate & ECB Main Refinancing Operations Rate (key interest rate currently at 4.0%). Note the ramp-up in the 3- month Euribor rate in early August on the emergence of the US subprime-related credit crunch. - - Source: Central Bank and Financial Services Authority of Ireland |
European Central Bank President Jean-Claude Trichet said at the press conference on Thursday following the decision of the Governing Council to keep its key interest rate on hold at 4.00%, that price stability is the "only needle" in the Bank's compass. He said that the secondary effects of the recent surge in Eurozone inflation, such as a pass-through to wage increases, were a key factor to consider as regards the medium term, as are inflation expectations.
The ECB also announced on Thursday that it would again inject €60bn in each of two separate operations to ease tensions in the three-month money market – an acknowledgment that market turmoil remains.
With the credit markets still in turmoil, commodity prices surging and the US dollar hitting new lows while uncertainty surrounds the outcome of the Dec 11th meeting of the interest rate setting Federal Open Market Committee of the US Federal Reserve, nobody knows what the stance of the ECB will be on rates in 2008, despite wishes for a particular outcome.
In May 2006, economist Austin Hughes of IIB Bank, said "our view remains that the ECB will raise policy rates to 3% by end year." The outcome was a rate of 3.5% while Bank of Ireland's Dan McLaughlin said in Oct 2006: "The ECB has made it plain that another quarter point increase is virtually certain in December...we expect rates to peak at 3.5%."
Both Austin Hughes and Dan McLaughlin are now forecasting ECB rate cuts in the first half of 2008.
In a commentary on the Thursday's ECB press conference, Ulster Bank economist Simon Barry said in relation to interest rate policy: "its tightening bias remains in place and there is no indication from the ECB that lower rates are on the agenda."
Austin Hughes commented: "Our view is that by the time uncertainty diminishes, the outlook for growth and inflation will have begun to point in the direction of lower rather than higher ECB interest rates."
Hughes says that he expects the global economic outlook to worsen in coming months. So a rate cut may come at the cost of a US recession. Is this the case of an optimist "talking down" the global economy?
Ralph Atkins, the Financial Times correspondent in Frankfurt, writes today: Trichet acknowledged the downside risks to Eurozone growth, which reinforced financial market expectations that the ECB’s interest rates would remain at 4% until well into 2008 – and possibly into 2009.
So tossing a coin is likely to be as fruitful in taking a punt on ECB rate moves in 2008, as depending on current forecasts would be.
Remember that US subprime problem, which hit the headlines last February when global bank HSBC announced billion in losses? It was a surprise of course but in subsequent months, almost all the Wall Street "experts" appearing on the CNBC business television channel, spoke as one - subprime was a small part of the US mortgage market and "contained" was the mot du jour. Now the line is that the woolly academic Bernanke, must step up to the plate and produce more rate cuts.
A good dose of scepticism is clearly no harm for the punters beyond, including in Europe.
Simon Barry, Senior Economist - Associate Director, Corporate Markets Ulster Bank Group:
The ECB again leaves euro zone rates on hold at 4% as expected...
...but inflation concerns remain to the fore...
... inflation is likely to average at least 2.2% in 2008...
...the 9th consecutive year in which inflation is above ECB's target...
...but the growth environment is subject to downside risks...
...so rates are likely to remain on hold in coming months...
... no indication from the ECB that lower rates are on the agenda
The ECB left rates unchanged at 4% on Thursday, marking the fifth consecutive month of unchanged rates following the last move which was a 0.25% hike in June. This was the outcome that was fully expected by financial market analysts with all 77 economists in a recent poll expecting Thursday's decision.
Turning to the all-important press conference, the pre-meeting interest was in the relative emphasis that the ECB would place on signs of higher inflation vs. some indications of slower growth. But Trichet provided few major insights into the ECB's current view on this important issue.
He did acknowledge that higher than expected oil, non-oil commodity and food prices have resulted in a deterioration in the inflation picture. He noted the "very strong" increase in inflation from 2.1% in September to a two-year high of 2.6% in October and accepted that inflation is expected to remain "significantly above 2% in the coming months". While the ECB had been expecting inflation to move higher in the latter part of this year due to base effects, the outlook is now for that spike higher to be larger than previously expected and for it to last somewhat longer, reflecting the additional upward impetus from the latest surge higher in commodity and food prices. Crude oil costs in euro terms have risen by 16% in the past month alone, for example.
Indeed, it looks as if inflation could push to 2.9% by the end of the year, and possibly even hit the 3% mark. And while Trichet refused to be drawn on what this means for the December update of the ECB staff forecast for 2008, it seems clear to us that next year's average inflation rate is set to be revised to 2.2/2.3% and maybe higher, up from the 2% projected last time (in September). This is clearly not a welcome development from the ECB's perspective, as it means that 2008 will in all likelihood be the ninth consecutive year in which the ECB will have failed to keep inflation in line with its target of "close to but below 2%". Trichet also made clear that the ECB is following the evolution of inflation expectations particularly closely at the moment and highlighted the recent rise in bond market-based measures of this.
On the growth front, the ECB is maintaining its base case of growth around potential (which is around 0.5% per quarter, or 2% in annual terms) for 2008. Despite a number of positive fundamentals including strong corporate profitability and unemployment at 25-year lows, the risks to the outlook are on the downside in the ECB's view. The impact of ongoing financial market volatility is the source of one of the downside risks, as is the possibility of further rises in oil and commodity prices, and given the state of financial markets at the moment the uncertainty surrounding the growth outlook remains high. Also, the ECB appears a little less positive on the international environment; the global economy is expected to remain "resilient" according to this month's statement, whereas last month it was expected to remain "robust". The language on recent confidence indicators from the zone was also qualified a little; these "generally remain above their historic averages" (the phrase "generally" did not appear last time - an acknowledgement that some indicators such as the manufacturing PMI have slipped below average levels).
The ECB's overall assessment is that the latest information "fully confirms" that the outlook for inflation is subject to upside risks, a modest firming of its stance relative to last time when the word "fully" was absent. But the uncertain growth environment is likely to see the ECB remaining on hold for the foreseeable future. However, its tightening bias remains in place and there is no indication from the ECB that lower rates are on the agenda.
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| ECB President Jean-Claude Trichet introduces German Chancellor Dr. Angela Merkel to staff, at the Bank's headquarters in Frankfurt. |
Austin Hughes, Chief Economist IIB Bank:
And downplays significance of higher inflation in coming months
The ECB raised rates 8 times between December 2005 and June 2007, we reckon the stronger exchange rate of the Euro has been the equivalent of an additional 5 interest rate increases
Since the ECB last raised rates in June the rise in the Euro equates to 2 rate hikes
We think ongoing financial market woes, a weaker US economy and softer Euro zone surveys will begin to point towards lower interest rates in 2008
As expected the European central bank left interest rates unchanged Thursday and at the subsequent press conference Mr. Trichet, the ECB President suggested that the ECB does not intend to change rates at any time in the near future. This is the time when central bankers really earn their money. With inflation risks apparently to the upside, growth risks to the downside and financial market very nervous, any ill judged comment or action could cause huge problems for an economy. As a result it is understandable that European Central Bank is suggesting it is likely remain on the sidelines for some.
While the message of Thursday’s press conference was broadly similar to that of a month ago, there were three aspects of Thursday’s statement that seem worthy of comment. First of all, its seems that the ECB now thinks turmoil in the financial markets will last longer and have a more significant impact than it previously reckoned. In part this reassessment simply reflects the extent of recent write-downs by US financial institutions. It also probably owes something to increasing pessimism in relation to the likely length and extent of weakness in the US housing market.
Reflecting the risk that market turmoil could persist for some time, Thursday’s ECB press statement gave greater prominence to current uncertainties. It also suggested that the ECB would carry out, ‘A thorough examination of additional information before drawing further conclusions for monitory policy.’ Our view is that by the time uncertainty diminishes, the outlook for growth and inflation will have begun to point in the direction of lower rather than higher ECB interest rates.
The second element of note Thursday is how Mr. Trichet handled the sharp jump in inflation from 2.1% in September to 2.6% in October, and the likelihood that inflation could threaten 3% in coming months. First of all Mr. Trichet did acknowledge these developments ‘fully’ confirmed that there are upside risks to price stability. Throughout a lively question and answer session, in which journalists probed whether higher inflation might need higher interest rates, Mr. Trichet recognised that inflation would likely rise further, but emphasised that this, ‘hump’ would be, ‘transitory.’ Clearly there are some on the ECB council who would favour higher rates but by emphasising that the spike in inflation should be temporary, Mr. Trichet tried to down play any suggestion that bad news on inflation in coming months would trigger interest rate increases by the European Central Bank.
As we noted previously, this is an approach the ECB adopted in the past. In May 2001 European Central Bank decided to cut interest rates, even though that was the month in which inflation peaked in the last cycle. Moreover, faced with a sharply weaker global economy, the European Central Bank continued to cut rates through 2001 and into 2002, even though core inflation continued to trend higher for nearly another year.
Of course, the European Central Bank is now facing the risk rather then the reality of a severe economic downturn. So talk of rate cuts is premature. However reading between the lines Thursday, one could detect signs of a further step down from the threat of higher rates. If, as we expect, the global outlook weakens further in coming months and survey data point to the prospect of softer Euro Zone activity in early 2008, the market will soon begin to think in terms of lower rather then higher ECB interest rates.
An important element in a changing economic and interest rate outlook is the behaviour of currency markets. There is little doubt that the seemingly relentless rise in the exchange rate of the Euro is emerging as a key issue for Euro area prospects. Since the ECB began raising rates in December 2005, a stronger currency has acted as additional restraint on activity and inflation.
The ECB raised rates by a quarter of a percent on 8 separate occasions. We reckon that over the same period of time, the rise in the trade weighted value of the Euro on foreign exchange markets is roughly the equivalent of a further 5 interest rate increases. While the bulk of the increase in official interest rates came in 2006, a good deal of the exchange rate effect has been relatively recent.
We estimate that the strength of the Euro on currency markets since June, when the ECB last hiked interest rates, is the equivalent 2 rate increases. One of which has come in the past month.
With the Euro continuing to threaten new all time highs, it is not surprising that Mr. Trichet was relatively cautious in his comments. Certainly they stand in stark contrast with yesterday’s speech by French President, Nicholas Sarkozy. Speaking to the US Congress, he sounded a very stark warning about the importance of a continuously appreciating Euro, ‘The dollar can not remain solely the problem of others of others. If we are not careful monetary disarray could morph into economic war we would all be its victims.’ Mr. Trichet’s remarks Thursday were exceptionally guarded in comparison. However it is clear that behind the scenes the stronger Euro is one significant factor among several that we think will ultimately push towards lower European interest rates in 2008.
