How to read the ECB latest comments

Jean-Claude Trichet's balanced statement after today's council meeting suggests that we are getting close to the interest rate peak in the euro area - certainly for this year. We expect a further rate rise later this year - but only if growth conditions remain as buoyant as they are now and as long as the real effective exchange rate remains broadly at current levels. If we had to place bet, we would go for 4.25% in September or October, and nothing more for the rest of the year.

 

Until this week, we had favoured a peak of 4%, but the unexpected strong economic growth and some reports of capacity constraints in some sector now warrants somewhat tighter conditions in our view. We are happy with a rate of 4.25%, and believe this is also the view of the majority of the ECB council.

 

Trichet's cautious statement also suggests that we have reached the end of the universal policy consensus within the ECB's governing council. There was an overwhelming consensus in favour of going up to 4%, but the different views on specific issues of policies are now becoming more relevant. Perhaps the most important of these issues is the significance of the ECB's monetary analysis, and even among those who take it very seriously, there is a difference of views of how to interpret the latest data. The headline data, M3, are meaningless. Much of the recent increase in M3 is due to portfolio shifts into the short-term end of the yield curve, and to inflows of hot money from abroad. The question is whether the low-frequency data carry any meaning. Unfortunately, the ECB does not release these data - possibly because they not sure how to interpret the data themselves. The credit statistics show that the recent rate increases are already affecting consumer spending, but not yet business investment, though this is to be expected at this stage of the interest rate cycle. We believe that the monetary indicators carry important signals, and that the ECB was right to justify the rise in interest rates two years ago on the basis of strong money and credit growth. We are just not persuaded that a lot more tightening is needed to do the job.

 

Note that the ECB's staff inflation forecast for 2007 and 2008 coincides with the ECB upper end of its target range - 2%. With the output gap turning positive, a Taylor-rule argument would suggest a slight tightening bias. With neutral rates somewhere between 3.5% and 4%, we think that 4.25% would probably be justified on the basis of what we know today. If in the next months, further inflationary pressure were to surface as a result of energy price developments, or due to unfavourable developments in labour markets, we would, of course, revisit this situation again. But for now, 4.25% seems to be a good number.

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