Probably one more rate rise this year

We are sticking with our forecast of another ECB rate rise at some point this year. This is not because we think that the ECB is actually planning to do this. On the contrary, the current consensus on the governing council is not to do this. The governing council accepted a classic compromise on Thursday: It agreed to an increase policy rates by a quarter point, while at the same time communicating to the outside world that the present policy stance is neutral. We believe them.

 

We also agree that if the consensus forecast on inflation were to prove correct, that this would indeed mean the peak of rate rising cycle. The consensus holds for a further small increase in headline inflation, to perhaps 4.2% by August, and then for headline inflation to fall back gradually. Under the present scenario, the ECB would reach its 2% target at some time towards the end of next year. On the basis of this trajectory, the present policy stance would be indeed appropriate. Since the ECB’s inflation target is medium-term, it does not need to run after every number.

 

However, we just do not believe that this consensus inflation forecast is correct. First, all inflation forecasts in the recent past have proved persistently too optimistic. We do not pretend to have any insights into the oil price. We do not, however, believe the story the rise in the oil is some freak accident, driven by speculation, or some short-term supply conditions, that will soon reverse. We agree in principal with the latest analysis by the Bank of International Settlements. Long periods excessive money and credit have led to contagious bubbles in various segments of the financial markets, before reaching the commodity markets, where it translates directly into higher prices.

 

Wages growth is still moderate, though picking up slowly. In Belgium, Spain and Luxembourg, wage indexing makes second round effects semi-automatic. In Germany, wages are still rising at levels below inflation – meaning that real wages are still falling. This situation will – and should - end eventually. We do not predict a dramatic increase in second-round effects in the euro area over the next few months, but if inflation were to hover close to 4% by the end of this year, trade unions would be demanding 4% plus share of productivity growth next year, in other words a total wage increase in the order of 5-6%. This would not be totally unreasonable from their perspective, but if it were to happen, it would make the ECB’s policy choices a lot harder.

 

At that point, the ECB would have to confront either a punitive  rate rising cycle, going to 5, perhaps even 6%, to squeeze inflationary expectations out of the system – effectively by forcing the euro area into a recession - or to accept the ultimate humiliation of a permanent increase in its inflation target. We believe that the ECB will want to avoid either scenario, especially the latter, and will prefer to make a pre-emptive rate increase beforehand, sometime this autumn. We don’t think this is going to happen in September, but October, November or even December are all distinct possibilities.

 

This would naturally create a big political row, but this would actually serve the ECB’s main purpose: to underline its strong anti-inflationary commitments in the wake of strong political opposition. Of course, a quarter point rate increase is not going to make much difference in itself, but the combined effect of two quarter point rate increases at a time when inflationary are still reasonably well anchored should have some impact.

 

What makes this scenario also feasible is the fact that the economy is holding up relatively well. The global economy is slowing, but in our view the main story is not the steepness of the decline in global growth, but the length of the downturn. We are not going to see a global recession, perhaps a US recession, and certainly no euro area recession, though economic growth is likely to fall below potential in 2009. It would be politically a lot more difficult for the ECB to raise interest rates in 2009 than in 2008. A small rate rise this autumn is thus a good insurance policy against large, very pro-cyclical, and very controversial series of rate rises in 2009. If inflation does not fall markedly back by September, the ECB will move again. This will also be the time when the next inflation forecast is out. If this remains outside the trajectory, expect a rate increase as early as October.

Eurointelligence ECB Watch

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