Euro interest rates to go up to 4.5% this year? You must be kidding.

In the last few days several banks have upped their interest rate forecasts. They now say that European policy rates may hit 4.5% as early as this autumn. While this is not yet the consensus, there appears to be a general trend among ECB watchers to revise their forecasts upwards.

 

Our main forecast remains for a 4% interest rate by June, but we are very cautious about the outlook further down the road. It is true that recent data show strong growth in the euro area, and this week’s M3 growth of 10% in February may have spooked the markets, but there is little in either the M3 growth numbers, nor in the inflation forecasts that would suggest that excessive policy tightening is necessary for the ECB to remain on target. As we reported on previous occasions, the policy rate that is consistent with current forecast is 3.5% - less than today’s.

 

We are cautious for the following six reasons reasons.

 

1. There is currently no sign of an inflationary pickup in wage settlements. German wage negotiators may be ending the period of wage moderation, but they are at worst shifting into neutral, with pay rising at levels below the sum of inflation and labour productivity increases.
2. The ECB’s own staff inflation forecasts suggest that there is, on present policy rates, no reason to expect an increase in HICP inflation above the 2% target.
3. The M3 data may well be distorted through the carry trade – watch out for the February data on net external assets of the euro area financial sector!. Furthermore, as ECB board member Lorenzo Bini-Smaghi correctly pointed out, the flat yield curve means that investors are shifting into short-term money, thereby raising M3.
4. There is already evidence that the increase in market rates from 2% to 4% already has had an effect on consumer spending. They have had little effect on business yet, but we doubt that even a couple of more increases are going to make much of a difference, while they would certainly hurt the consumer.
5. There is increasing evidence that the US economy could slow down in the second and third quarters, due to the subprime mortgage disasters and its spillovers to the housing market and the real economy and to other parts of the financial system. While none of this has any impact on European policy in the first half, the ECB will clearly take on board the implications of a US slowdown, especially if this was accompanied even by a even small degree of financial market contagion.
6. If the Fed were to cut interest rates and the ECB were to lower interest rates, we should expect significant flows of funds from the US, and elsewhere, into the euro area. Some observers are talking about a 75bp cut in the Fed Funds rate this year. If the ECB were to raise to 4.5% by year-end as some European observers now believe, this would imply identical nominal short-term rates by year-end, but significantly higher real rates in the eurozone. This could lead to a serious upward adjustment of the euro/dollar exchange rate. This is a situation the ECB will probably want to avoid.

 

 

What appears to have happened is that the interest rate forecasting models by some banks – which include factors such growth, employment, credit – are now pointing towards higher rates for obvious reasons. But these are obviously not attuned to issues such political pressures, or spillovers from the subprime mortgage sectors to other parts of the financial system, or from the US to the rest of the world. The central bankers we talk to see both aspects very clear, and at least to us appear capable of forming a clear judgement.

 

Or let us put in these stark terms: If the ECB were to tighten without any concrete inflationary pressures on the horizon on the basis of a mere hunch that inflationary pressures may be higher than we think, and if the ECB got that call wrong, sparks would fly. The ECB would stand justly accused of ending the euro area’s economic boom out of pure paranoia, and politicians and economists will raise once again the issue of the ECB’s independence, its goals, or both. If the ECB had any sense, it would stick to a more sober assessment of inflation risks. Even a rate rise to 4% may not be that easy to defend given the current inflation outlook, but we assume now that this rate increase is forthcoming, given recent comments from several central bankers. Going above 4% without any concrete sign of inflationary pressures in the pipeline would imply an unnecessary risk for the ECB to take, and it is our view that Europe’s central bankers are risk-averse.

 

 

Email:

munchau(at)eurointelligence.com

mundschenk(at)eurointelligence.com

 

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