What explains the gap in euro area interest rate expectations?

The financial markets tell us that euro area interest rates should go up to 4.25% by the end of this year. There are broadly two groups of analysts who disagree with this scenario. A typical representative of the first group is us: Our call is for a rate rise to 4% in June, to be followed by an extended pause for the rest of the year. On the other extreme is, for example, UniCredit, who predict that rates will go up to 4.5% by the year-end.

 

UniCredit's April edition of the "Eurozone Monthy Compass", one of the better economic publications of the euro area, gave an extended justification of its daring interest rate call. Many aspects of their analysis are close to our own. The reasons we arrive at totally different conclusions have almost nothing to do with difference perceptions of euro area economic performance, inflation, or ECB hawkishness. The main differences are our scenarios for the US economy, and the euro/dollar exchange rate.

 

We are probably all agree that the euro area enjoys strong economic dynamism, and the 2007 growth rate will be significantly above 2%, possibly approaching 3% (The ECB has been predicting a growth rate of 2.5%). We are also agreed that inflation pressures are relatively modest right now, but may rise for technical reasons later on in the year. We are probably also agreed that the cost-push pressure from wage increases (especially the much-feared German wage round) is going to be modest this year. While there are always commentators who would have preferred a smaller settlement in the German engineering sector than the agreed 4.1% pay rise, this figure is still less than the sum of expected inflation and productivity growth - and hence non-inflationary. Inflationary expectations are significantly more contained in the euro area than in the UK or the US.

 

UniCredit's analysis of the ECB's stance is based, and supported, by the following observations, all taken from recent comments by ECB governing council members:

 

1. The Luxembourg ECB governor Yves Mersh was quoted as saying that the ECB might adopt a restrictive stance, if there is no evidence of a rise in productivity and potential growth.

2. Axel Weber, president of the Bundesbank, said German upturns on average last seven years, and we are now in year four of the present upswing. This suggests that the Bundesbank believes that the upswing has still some time to go.

3. Nout Wellink, governor of the Dutch central bank, said the EU had no problem with the current level of the euro. UniCredit estimates that since February the rise in the effective exchange rate of the euro was equivalent to a 25bp rise in interest rates. But the ECB is not going to be swayed by this argument for two reasons. First, the stronger euro has not affected GDP growth forecasts. Second, it has not affect M3 growth.

4. Quoting Wellink again: in terms of interest rates, rates are still well below the peak of the last cycle (4.75%).

5. The Austrian central bank governor Klaus Liebscher said the ECB would announce when rates are close to a peak "when the time comes". It has not done so yet.

 

As for point 1 (potential growth), we agree with that statement, except that it will not be obvious for some time whether potential growth has gone up or not. As far as point 2 (length of economic cycle) is concerned, we are sceptical about such a mechanistic approach. We may be in year four of a seven year cycle, but we may already be in year five or six if you make some adjustments to the beginning of the current cycle. The dotcom bubble may have artificially prolonged the last cycle, and its bursting may have shortened the present cycle. As far as the exchange rate is concerned - point 3 - we differ from UniCredit in substance. Yes, we agree that if the euro's effective exchange rate rises were to remain at approximately current levels (as UniCredit expects), European interest rates are indeed likely to rise to 4.25% by the autumn, and even higher by the winter. We just do not believe that the exchange rate is going to remain at current levels. In our view the ECB's ability to raise rates beyond 4% will be constrained by an appreciating euro - and, coupled with this, a sudden emergence of pressure from industry and politics (which is absent now). Point 4 - the comparison with the previous cycle - is true but meaningless, for the same reason as point 2. As far as point 5 is concerned (ECB's pre-announcement strategy), we agree in principle but would caution anybody to assume that the ECB has any better ex-ante knowledge of its own rate-setting behaviour in the medium term (i.e. for more than three months) than the rest of us do. It may well be that Mr Liebscher will suddenly tell us in the summer that rates are close to their peak.

 

The two most important factors that separate the optimists from the pessimists are the performance of the US economy and, close related to this, the euro/dollar exchange rate. UniCredit's qualifier says it all: "Still, it's indisputable that if the current pace of currency appreciation were to persist also in coming months, then the ECB would probably prefer to take a prolonged paused at 4%." The difference is that their conditional scenario is our mainstream scenario.

 

Likewise, even though we do not believe that the world economy can de-couple from the US, we acknowledge the point made by UniCredit and others that a moderate form of de-coupling from the US is likely if the US slowdown is largely domestically driven (by the housing market for example), and if it is not extreme. Everybody is agreed that the world economy will under no circumstances decouple a recession-hit US economy.

 

The euro area optimists and pessimists agree more about the euro area itself than about the US. The market consensus for a 2007 interest peak of 4.25% in some respect reflects an expectation that the truth lies somewhere between those two extremes. But be careful: this does not mean that the market's prediction is in any way safer than UniCredit's or our own.

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