With the Euro at $1.35 and Y160, who needs higher interest rates?

Trying to follow every nuance of Jean-Claude Trichet’s apparent degree of hawkishness is a waste of time in our view. It is clear – and has been for some time – that the ECB will probably raise rates in June. We are not sure this is an appropriate decision, but one would be ill advised to bet against it. The thing to watch out for is not Mr Trichet’s next speech, but the euro’s exchange rate. Our view is that the euro is highly likely to appreciate in effective nominal terms. And this is the core reason why we believe that the ECB is going to stop at 4%.

 

The markets are still expecting a rate of 4.25% a year from now, as evidenced by the one-year Euribor.

 

 

Some banks, like HVB, believe that the ECB will move up to 4.5% as early as this year. The argument of HVB and other hawks is that it is relatively risk-free to raise rates given the robust growth, and it is also likely that the current growth rates lead to labour market shortages that are bound to translate into higher wage inflation. There is presently no evidence that this is happening, and we find it very difficult indeed to make an inflation argument in favour of higher rates. Even the ECB’s own internal forecasts point towards modest inflationary pressures in the medium term.

 

But even if you could make such an argument, it would be a mistake to assume that the ECB can simply raise short-term interest rates by a total of 75 basis points, without any impact on the euro’s exchange rate. The euro is already trading at above 160 yen, and the dollar has fallen to $1.35 per euro. The following chart shows the most recent rise in the euro’s effective nominal exchange rate.

 

 

This is a fairly dramatic increase, and there may be more to come, as the Bank of Japan remains very slow in adjusting monetary policy, a situation that encourages large outflows of Japanese savings to the euro and dollar areas. The carry trade continues healthily, and the G7 is doing nothing about it. The European politicians, for now, have lost interest in an exchange rate policy. But this is a fool’s paradise. An overshoot of the euro is not only going to dampen economic growth, as it did in the past, but also put a lid on inflation. By going to 4.25% or even 4.5% the ECB would seriously risk not only an overshooting euro, but also an undershooting inflation rate, and provoke serious criticism from European politicians.

 

The following chart shows the euro area’s monitory conditions, right until end of February.

 

 

 

 

The main index is composed of two subindices, real interest rates, and the real exchange rate. Over the last month, the real exchange rate would have risen significantly, as would have real interest rates, given the ECB’s March rate rise. So by now, the overall index will be well into positive terroritory – meaning that monetary conditions are no longer lose (not even “on the accomodative side”, as Mr Trichet likes to say), but already restrictive. A rise in the repo rate to 4%, combined with a euro/dollar rate of close to $1.40 is all the tightness the euro area needs to stay on course. There is presently no need for a monetary clampdown.

 

We would therefore strongly advise our readers not to buy into the current interest rate hype. The hawkishness you currently think you hear out of Frankfurt and from some of the other national central banks does not reflect a sense that the central bank is “behind the curve”. It is merely a signal that rates will go up in June. But this you know already.

 

By June, also, we will have a clearer idea about the outcome of the German wage round. It is our view that the ECB decided to put on the pressure for as long as possible. We think that German wages are going to rise at a relatively modest rate (under 4% in booming industrial sectors, less in the services and much less in the public sector). The average annual nominal rate increase will be about 3%, perhaps less. While Germany is not going to boost its relatively competitiveness by much this year (it may still do so by a little), there is virtually no chance of an inflationary wage increase across the entire economy. By the summer that will become more and more apparent, and the wage dynamic will suddenly cease to be a factor in the ECB’s policy deliberations. Provided that the oil price does not suddenly rise again – which does not appear likely either – the ECB is going to run out of reasons to justify any paranoia about future inflation (though we should not perhaps underestimate their resourcefulness in finding new reasons!)

 

By the second half of this year, we would expect to see more evidence of weakness in the US economy, not necessarily a recession, but a decline in economic growth that may well force the Fed to lower interest rates before it manages to get core inflation back into its own comfort zone of between 1 and 2%. In such a scenario it is very difficult to imagine that the Europeans would continue raising interest rates further, as such a course of action would have serious consequences for the exchange rate. Also think of the political consequences, given that whoever is elected president of France would almost certainly pick a fight with the ECB on this subject, and he may yet find an uncomfortable large number of allies.

 

Politics and economics all suggest to us that 4% is the limit, unless there is concrete new evidence of inflationary pressures. We do not see this happening right now – and until we do, we will stick with our forecast.

 

munchau(at)eurointelligence.com

mundschenk(at)eurointelligence.com

 

 

 

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