Beyond 4.25%

By: Eurointelligence ECB Watch

The European Central Bank is now almost certain to raise the short-term interest rate to 4.25% in July. We would expect another rate rise to 4.5% later in the year. If the ECB’s optimistic growth forecasts prove correct – we are not entirely sure about this – a further rate rise this year cannot be excluded. We would, however, caution against assuming too much rate hiking zeal. The governing council is split on this issue – more so than ever before. Bundesbank president Axel Weber has been aggressively pushing for a rate hike the council has finally caved in. Failure to raise interest rates, and continued inflation surprises, would have led to increasing criticism – and not just from us – that the ECB has effectively given up on the 2% inflation target (never mind the “close to, but below” bit). Such criticism would have also come from the inside, and it would have come publicly, and the ECB wanted to avoid such a dispute. Another rate rise is going to calm the hawks, but they are invariably going to ask for more. Our best guess is another 50bp this year, and then a long period of “wait and see”.

 

The policy response will also depend on the situation on the money markets. With 3-month Libor, the most important benchmark, close to 5%, the ECB did not need to raise interest rates in the last few months. But as the money market rates start to converge towards policy rates – which is going to happen eventually – leaving policy rates unchanged would have been equivalent to a rate cut. Conversely, a rise in policy rates will not imply a rise in actual interest rates. The ECB’s policy course merely ensures that current money market rates are stabilising at around the current  level. Of course, the rise in policy rate also sends out an important signal – that the ECB remains committed to its inflation target, a signal which the money market rates obviously cannot transmit.

 

So how about the argument that a fall in growth will take care of the inflation problem? We are not sure that this is how the mechanism will work in practice. Some analysts have bet on a rate cut, assuming that the ECB would act similarly to the way it did back in 2001, when it cut rates despite the fact that inflation was rising. The mistake these analysts have made is that the ECB cut rates then on the grounds that both the inflation forecast and the monetary analysis suggested that it was safe to do so. This is not the case at the moment. Money and credit are still expanding at excessive rates. The staff inflation projection – which includes no second round effects – suggests a median inflation rate of 2.6% for 2009, in a range of 1.8% to 3.0%. This means that the ECB would only hit its target on the most optimistic end of the projection. If the ECB did not act, it would risk a serious inflation overshoot for the third year running, and with each year, surely the risk of second-round effects is rising. European consumers are suffering from a clear loss of purchasing power, and in the absence of a recession they are quite likely to try to recoup this in terms of higher wage settlements.

 

The upshot of all this is that the euro area’s inflation performance will be significantly better than that of the US or the UK. In the US, Bernanke talks about the desirability of price stability, but remains in denial over the impact of the Fed’s policy on the inflation process in the US. In the UK, monetary policy is also too lose, as the monetary policy committee seems reluctant to enforce its inflation target at a time when house prices are crashing.

 

There are doves on the ECB governing council as well, even governors who would accept a permanent rise in the inflation  target. But we assume that a solid majority on the board remains committed to the target – despite the fact that they disagree on the diagnosis. We were not so sure about this before.

 

 

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