Our position revisited - The case for raising interest rates beyond 4%

On Thursday, the ECB will raise interest rates to 4%. The financial markets further expect rate increases this year - with estimates ranging from 4.25-4.75%. In the discussion about the future course of European monetary policy, one hears the following arguments in favour of a rate rise beyond 4%

 

1. Monetary Expansion remains strong, with M3 growing at rates at over 10%.

2. The euro area economy shows significant above-potential growth, as capacity constraints are building up.

3. Wage pressures are rising.

4. Producer prices and oil prices are rising.

 

Some of these points have become increasingly valid, while others have not. We also come around to the view that there may now be a case for raising interest above 4% in the autumn, contrary to our previous call that interest rates should peak at that rate. The reason is that output is growing at higher rates than we expected. We are still not convinced that we are about to witness a big build-up in inflationary pressures, but there is some evidence of rising capacity constraints, which itself is due to the much stronger than expected economic growth rates during the second quarter. Let us look at these four arguments in turn.

 

1. The monetary expansion remains strong, but a more sober monetary analysis suggests that the current high-growth rates of money are mostly due to inflows of hot money. The March balance of payments statistics confirm that portfolio inflows are now running at the highest level since the creation of the euro area, and with short-term nominal interest rates on the rise, there is a significant amount of flows into the shorter aggregates that are captured by the rise in M3. On the counterparts side, lending to the private sector, especially mortgage lending, is coming down nicely from the previous peaks. Monetary analysis gives a full justification of the ECB's decision to have started rising interest as early as November 2005, and also for the trajectory until now, but it does not necessarily give a clear-cut picture of why interest rates have to rise much beyond 4%.

 

2. Clearly, a straightforward application of the Taylor rule must point towards a trajectory of higher interest rates than previously expected. On our very rough calculation, with inflation expectation broadly in line with the inflation target, and with output growing at about 1% above potential, the nominal interest rate effect is about 0.5%. With a neutral rate of around 4%, the traditional Taylor rule tells us that the optimal interest rate is somewhere close to 4.5%. Since in our view, the neutral rate is a little lower than 4%, the ECB may well rest at 4.25% (If you are using modified versions of the Taylor rule, for example, combining M3 target overshoots with the purchasing manager index, then you arrive at some different - in this case even higher - estimates). But in any case: If all other things remain equal, including the exchange rate, the ECB would probably be justified to raise interest rates after the summer holiday. In fact, the ECB may even be justified to raise rates this week by a full 0.5% though we think this is very unlikely.

 

3. Furthermore, there is anecdotal evidence of capacity constrains building up in some sectors. We have heard of sudden and substantial price increases in the German construction sector, as builders cannot meet demand. However, it is important that we put this into perspective. In the past, European economies would be well on their way to create inflationary pressures at this point in the cycle. Wages would at this point have already reacted to the increase in demand. This has by and large not happened this year. The German wage round, the most important in the euro area, has yielded modest wage rises (although there is now a strike looming in the German construction sector, which may well result in a higher wage settlement). Average earnings, however, will rise at less than 3% this year, which remains a modest number after the unusually long period of wage moderation beforehand. There remains some degree of wage stickiness in other euro area economies, especially in southern Europe, but there is no real sign of significant cost-push wage inflation.

 

However, while in the past German wages constituted a downward pressure on euro area inflation, this is no longer the case. We are therefore returning to a more normal situation, and this may explain some of the central bankers scepticism about the labour market. If the present output growth were to persist into 2008, wage pressures may build up in the next wage round, and central bankers may want to ensure that capacity constraints do not become to extreme to encourage cost-push inflation. This forward-looking argument is possibly the only reason why anybody can still reasonably claim to be concerned about wage developments. In our view, there has been a structural break in the euro area labour market, as a result of which wages do shift as fast to demand shocks as they used in the past. We are certain that wages make no significant contribution to HICP inflation this year, and we do not think it very likely that they will push up inflation next year either.

 

4. Producer prices are growing at the highest levels since 1995. Headline producer price growth of 2.4% growth is supported by favourable base effects. Core producer prices, by contrast, are growing at 3.4% annually. This is about the high end of the prevailing range since 1995. This would support the capacity constraint view. And this is also consistent with the ECB's probable increase in the inflation forecast. Oil prices are also rising again. While the ECB should not, and does not accommodate every oil price rise, monetary policy nevertheless has to take into account the price pressures result from a sustained price in oil prices. There are some mild inflationary pressures in the pipeline. While these are not strong, they will weigh on the ECB's behaviour.

 

All in all, the more robust economic growth rates in the euro area suggest to us that the ECB will probably raise rates beyond 4%. However, a further appreciation of the real exchange of the euro, or indications of a fall in economic growth from current peaks, may well put a break on any further upward movement in interest rates. Remember: the ECB adjusts fully, but rarely in time. Events can get in the way.

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