The times they are a-changin’…

It will be a tough autumn for the ECB. The stream of declines

in major business surveys confirmed that the credit market

crisis, and the consequent crunch in the money market, risks

taking a (heavy) toll on the growth outlook. At the same time,

CPI inflation – led by energy and food prices – is at the inception

of a sharp acceleration and, although so far market

measures of inflation expectations have remained well anchored,

the ongoing yield curve steepening suggests that the

ECB may face a tough dilemma in the near future.

Faced with an unprecedented crisis on the money market,

the ECB has adopted a wait-and-see strategy on the policy

rate, while providing liquidity (overnight and at term) to the

banking system at regular rates with no penalty. In our view,

this is the right course of action. Let us also add that we find

rather theoretical and doubtfully useful the ongoing debate

on moral hazard. Certainly, the central banks’ responsibilities

for the credit meltdown, together with the appropriate policy

responses have to be addressed once the crisis is over. But

when your money market is simply blocked, confidence in

counterparties’ solvency is missing, and a massive credit rationing

scenario may soon become reality, you only need to

find the right tools to come out of the woods. Therefore, the

ECB needs to keep rates on hold and continue to provide liquidity

to the system, while striving to rebuild trust and restore

proper working conditions in the interbank market.

 

Monetary tightening already in place

 

The money market crisis and the euro climb above 1.40 already

made the tightening job, and we think the ECB should

no longer need to stick to its pledge that the 25bp restriction

scheduled for September has been postponed, rather than

canceled. Notice that the technical exchange rates assumption

for September 6 staff forecasts was a stable EUR/USD

at 1.37, whereas oil was assumed at USD 68.1 a barrel in

2007, and USD 71.9 in 2008. At the time of writing, the former

is trading at 1.4270, and Brent is hovering around USD

82pb. By resorting to the usual rules of thumb, a moderate

haircut to growth perspectives should be applied. Notice that

last month the ECB lowered to 2.5% its 2007 growth forecasts

and left unchanged at 2.3% the 2008 call, thus implying

an acceleration in the first half of next year that at the

moment appears unlikely. We doubt this is still the view of

both ECB Staff and, more important, of the Council.

 

Tightening bias likely to be dropped

Against a background of “tighter market financing conditions

due to higher average risk premia”, exacerbated by stronger

euro and higher oil prices, as well as the sentiment deterioration,

we now see the ECB gradually moving away from its

tightening bias, keeping rates on hold over the next few quarters.

Our survey-based Taylor rule vindicates this reading. Assuming

that in August and September M3 corrected for portfolio

shifts stays at the July’s 11.7%, for the first time this year the

actual refi rate fell slightly behind the estimated outcome, after

holding the lead throughout the year. Until now, the message

was that the central bank has been clever in hiking

“pre-emptively” in order to face upside risks to growth stemming

from roaring confidence. However, in the near term, if

the business confidence (and therefore GDP) cycle inverts,

our indicator may start pointing to the necessity of accommodation.

We would not be surprised if over the next weeks, besides

lobbying politicians, the argument for a “pre-emptive” ECB

cut will become popular also among watchers and market

participants. In our central scenario, the ECB will not cut

rates. First of all, one has to wonder whether a rate cut may

be of any help. The credit crisis was not triggered by high interest

rates or by a too restrictive monetary policy. Moreover,

rising inflation in next months will result in lower real rates.

Plus, the ECB’s stance should not undermine price stability.

Given the usual coincident relationship between actual figures

and inflation gauges, the central bank needs to avoid

any abrupt shift in inflation expectations now that HICP is accelerating.

To this extent, the jump in the EC measure of

household inflation expectations to 26 from the previous 18.7

is more than a mere warning. For the ECB to consider the

possibility of a cut, we would need to witness a severe US

downturn that might bring the EUR toward unexplored peaks

– but recent rhetoric validates the impression that the central

banks still thinks that the eurozone will be able to decouple

from a moderate US slowdown – and/or a textbook credit

crunch with the bulk of firms and households no longer able

to borrow at affordable rates.

As far as the October 4 meeting is concerned, recent statements

by Constancio, Quaden (dovish), Trichet, Liebscher,

Weber, and Garganas (hawkish) confirm the impression that

a lively discussion within the Council will take place. At a

time when central bankers are still quite unaware of the real

shape of the banking system and how the credit squeeze is

going to impact on the credit channel to the economy, a

more cautious stance needs to be adopted. For the reasons

explained above, upside risks to inflation are likely to be

stressed again, but downside risks to growth will be emphasized,

the net outcome being a sort of move toward a more

neutral bias. One of the key sections of the September

statements read

“All in all, the data available suggest that economic activity in

the euro area is continuing to expand at sustained

rates…..global economic activity is expected to remain robust,

as the likely slowdown in the United States is expected

to be largely offset by the continued strong growth in emerging

markets. This will continue to provide support to euro

area exports and investment. In addition, consumption

growth in the euro area should strengthen further over time”.

We expect this section to be rethought, with the acknowledgement

of a steep rise in downside risks, if the PMIs deterioration

is anything to go by. We would also welcome the introduction

of some remarks on how the central bank deems

current FX movements in terms of its dampening effect on

growth and inflation. However, given the historical reluctance

to adopt a clear-cut view on currency movements, we doubt

we will read anything similar in the statement, rather only listen

to Trichet diplomatically addressing the issue when answering

the likely-several questions during the Q&A session.

In the next future, despite we are going to listen to the usual

sanguine remarks for some time, after the October meeting,

it will be clearer that the ECB has little left to do but carefully

watching the other side of the Atlantic and hope.

 

The author is co-head of European economics, global economics, and FI/FX research at Unicredit Markets & Investment Banking

Aurelio Maccario, Unicredit

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