So how about this rate increase?

By: Eurointelligence ECB Watch

We don’t often boast, but readers of Eurointelligence ECB Watch will probably have noticed that we have made two out-of-consensus calls, and were proven right on both occasions. The first was last summer, when we did not join the pre-crisis consensus that the ECB would go up all the way to 4.5% or higher. And earlier this year, we refused to join the consensus that confidently predicted Q2 rate cuts. So please keep that in mind before you dismiss our next call as the result of a lunatic disposition.

 

Most analysts have now put back their rate cut calls back to Q3. In fact, we think there might be no rate cut at all this year. At the moment, we would characterise the policy bias as neutral-with-a-moderate-tightening-bias. (see also the comments by Yves Mersh in Financial Times Deutschland) The economic case for tightening is overwhelming, as headline inflation has risen to rise to levels, that can no longer be described as a blip, and that clearly are no longer consistent with price stability. The ECB will fail to meet its inflation target of 2% (we don’t even bother with the “below but close to” adjunct any more) this year, and we doubt that they will meet it next year, as second-round effects are building up. It would a global depression for the ECB to meet their target, but neither ECB, nor any other institutional forecasters are ready to bet on such an outcome yet. The ECB also knows that all inflation forecasts – including its own – have turned out to be wrong. In fact it is quite rare for economic forecasts to be so consistently awful, The ECB is going to cut, if there is evidence of a sustained fall in inflation rates, and inflation expectations (which we do not seeing coming this year). The ECB is certainly not going to cut rates on such a flimsy basis as an inflation forecast.

 

One problem with the forecasts, both for inflation and for growth, is that they are inherently backward looking, as they are based on past data, and past structural relationships. These forecasts tend to overestimate the extent to which a euro area follows the US into a downturn.

 

There are three fundamental reasons for moderate optimism. One is macroeconomic regime change. We are no longer a group of small countries, but a large, and mostly closed economy, much more similar than to the US than to any of the euro area’s constituent members.

 

The second reason is structural reform. We remain sceptical on this claim. But there appears to be some evidence that the German labour market reforms may have reduced the country’s Nairu. But we still think it is way too early to assess the impact of microeconomic reforms on euro area output.

 

Third, we don’t have a credit crunch, and we are not going to get one. Some European banks are suffer no doubt, but we just cannot see the transmission mechanism of a credit cruch from the US to the euro area. There are no subprime mortgages over here, no Alt-A morgages, no mortgages that can be refinanced, no mortgages at more than 80% of the asset value (except in Spain, which is only a tiny bit of the euro area economy).

 

Even if one takes a very pessimistic view on euro area property prices – as some commentators do – we do not see why lenders should cut back on 80% mortgages, or why they should stop offer securitised car loans. In the UK or the US, where the property market is almost certain to fall by another 20%, we are understand perfectly well why lenders want to cut back on 100% or 90% mortgages. But mortgages are not dangerous overstretched in the euro area.

 

So we would concur with those who argue that the euro area will surely be affected by a mild global slowdown (which is still the IMF’s main scenario, and which we also accept). But we believe that a mild global slowdown would only translate into a mild euro area downturn. We expect the euro area growth to fall to close to potential, which is about 2% or a little less. It will be a little less than 2% this year, and 1.5% next, but probably not worse.

 

So what about the ECB’s monetary policy stance? With inflation at 3.6%, and no recession in sight, we believe that a nominal interest rate of 4% is too low. We would favour a rise in interest rates, even knowing that this would drive the euro further up against the dollar (which we believe will happen in any scenario). Obviously should our relatively optimistic growth expectation prove incorrect, the ECB would then need to cut rates more aggressively. There is a non-trivial risk, we admit, that a rate increase today could be reversed in Q4, but this is a risk we would accept. The alternative would be to keep rates at 4% now, and to keep them at 4% all the way through the downturn. While that would also eventually squeeze inflation out of the system, there is a danger of procyclicality. While we believe that the ECB’s policy of smaller nominal rate changes is vastly superior to the Fed’s reckless interest rate activism, there is a case for some action now. We know that some board members concur with that view, although we also believe that the majority of the governing council is probably not ready to raise rates yet. But the time will come when the current policy becomes very evidently inconsistent with the target. And this point is in our view not far off.

 

So these are our three scenarios: Keep interest rates at 4% throughout the year. Warn of a potential rate increase, but don’t do it (the ulimtate cop-out). And lastly, raise interests rate in Q2 even at the risk that a sharper than expected global downturn would require a reversal of that policy later on. What we predict with confidence is that a rate cut is off the agenda. Nobody is talking about cutting any more, while some are talking about raising.

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