Could interest rates stay at 4% for the rest of the year?

This is going to be our last ECB Watch before the summer break. For much of the last six months, we have argued that the ECB may not raise interest rates above 4%. We have subsequently upgraded our forecast to 4.25%, to come in either September or October, with no further rate rises this year. This forecast is still below market expectations. We stick to this number, but we believe that if there is a risk to this forecast, this risk is more on the downside than on the upside.

 

There are three reasons why the ECB might not raise rates any further in this cycle. The first is political. Further rate rise will accelerate the discussion of a co-ordinated exchange-rate policy. It is our reading of the situation that if it came to a fight, the ECB would probably loose. The Treaty also European finance ministers to give “orientations” over exchange-rate policy, and the ECB can hardly argue that preventing a euro overshoot would be inflationary. Jean-Claude Trichet is a central banker with a highly tuned political antenna. He will do anything to avoid a confrontation with Nicolas Sarkozy.

 

The second reason is the strong euro – which compensates for the rise in oil prices. The strong euro is the best insurance against inflation, and constitutes a substantial tightening of monetary conditions. The ECB’s governing council will probably disagree over the importance of the strong euro. Jurgen Stark, in charge of monetary policy at the ECB, this week made it absolutely clear that he see only upward inflation risks. Other central bankers will be more cautious. In the past, the ECB tended to postpone decisions in such situations, and may well see this again.

 

The third reason is a global reassessment of risk, as the European credit markets are in a state of near panic. The iTraxx crossover index has seen a remarkable increase in spreads this week (to over 300bp), as the troubles of the US subprime mortgages sector are spilling over into other parts of the credit market, and other regions of the world.

 

Reasons two and three suggest that there is still significant monetary tightening ahead, which originates in the financial markets themselves. This will allow the ECB to take a more relaxed stance than would otherwise be the case.

 

But there are also good reasons why the ECB may want to tighten further, at least a little. The first is the forecast rise in oil and food prices. This week, a warning has rattled the oil markets over tightening supply conditions five years down the road. Demand for food is rising faster than supply, and this has already led to an increase in food price inflation. The impact of globalisation on inflation is also reversing. Over the last decade, globalisation drove down prices for manufactured goods. Now, globalisation creates excess demands for finite resources.

 

The second problem is labour market shortages in the euro area, already apparent in Germany, where the era of competitive real devaluation is fast nearing its end, and as conditions in the labour market are returning to a normal level. There are acute shortages of engineers, which the German university system cannot deliver in the right quantities. The recent 4.5% wage agreement for train drivers may also be indicative of the wage pressures ahead.

 

The ECB policy choices are thus more finely balanced than meets the eye. We still think that the ECB will raise rates, but would not be surprised if euro policy rates would remain at 4% for a little while longer.

Eurointelligence ECB Watch

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