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| ECB Rate Rise Seems Certain in July |
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By
KBC Bank Ireland
Jun 13, 2011 |
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- ECB signals rate hike next month but attempts to keep some ‘wriggle room’.
- Less hawkish tone of ECB comments and non-threatening forecasts make markets less fearful of how far and how fast rates may rise through remainder of 2011 and into 2012.
- Uncertainty about Greece clearly argues against comments or action that might unnerve markets.
- ECB rates may not reach 2% until early 2012 but markets may be too complacent in this view.
- Weak Irish inflation suggests ‘real’ rates much higher here than elsewhere in the Eurozone.
As expected, ECB President Jean Claude Trichet today signalled an intention to raise official interest rates at the ECB’s next policy meeting on July 7. Mr Trichet did repeat the usual mantra that the ECB never pre-commits at today’s press conference and said had a decision been taken today to raise rates in a month’s time that he would have said this explicitly. However, these comments are only intended to provide the ECB with some ‘wriggle room’ should there be an explosive deterioration in financial market conditions. By including in today’s opening press statement the well established code words ‘strong vigilance is warranted’, the ECB indicated a clear intention to raise its key policy rates next month in the absence of a severe escalation in financial market strains.
The most notable feature of today’s ECB press conference was the market’s reaction to a number of subtle changes that reduced concerns that an aggressive sequence of rate increases might lie ahead. It seems very clear that the ECB wanted to engineer a calm market response to today’s comments. Mr Trichet made determined efforts to avoid providing any guidance on how ECB policy might change after July. In this regard, he indicated that he was ‘not signalling any particular pace for the next decisions’. It remains the case that further rate rises lie ahead but as Mario Draghi, Mr Trichet’s successor-in-waiting, noted earlier this week significant uncertainty at present ‘warrants an element of gradualism in changing standard and non-standard measures’.
A sense that the ECB is not poised to raise rates aggressively would also be consistent with the picture emerging from the new ECB economic projections released today. As expected, the mid-point of the inflation forecast for 2011 has been raised from 2.3% to 2.6%. However, the forecast for 2012 has been left unchanged at 1.7%. Strictly speaking, this may hint at a slight deterioration in inflation trends next year compared to the previous projection because the comparison with rapidly rising inflation in 2011 might be expected to produce an easing in measured inflation in 2012. However, markets appear to have expected that the ECB would signal significant inflation concerns by nudging up the inflation projection for 2012 as well as 2011. Significantly, today’s ECB press statement added a comforting interpretation of the new projections by indicating ‘overall, the projections embody the view that the recent high rates of inflation do not lead to broader-based inflationary pressures in the Euro area’.
A relatively cautious assessment of the economic outlook is also evident in the ECB’s new projections for economic activity. Again, the particular strength of Eurozone growth in the first quarter of 2011 implies the necessity for a mechanical upward revision to the GDP growth projection for this year to 1.9% from 1.7%. However, the ECB surprisingly cut their forecast for 2012 fractionally to 1.7% from 1.8%. It has to be acknowledged that this is a marginal change and Mr Trichet suggested the outlook was ‘broadly unchanged’. Again, this revision may be driven by technical factors rather than a notably changed perspective on 2012. However, both in terms of inflation and economic growth, the new ECB projections suggest that current strong momentum will give way to a more modest pace of increase next year. As a result, the trajectory of inflation and GDP growth doesn’t appear particularly threatening from a monetary policy perspective. Hence, markets have revised downwards their expectations for how far and how fast ECB rates may rise in the next year or so.
Yet another element in today’s press conference that eased market fears was Mr Trichet’s announcement that the ECB will continue conducting its principal liquidity operations that provide support for the Eurozone money markets at fixed rates and full allotment at least until the end of the third quarter of 2011. This reduces the risk of any additional liquidity problems for a range of banks in the more troubled Eurozone economies. Again, today’s announcement scarcely comes as a surprise. Any significant pull-back in liquidity support could have catastrophic implications for the functioning of the money market. So, it was almost inevitable that the ECB would not alter the status quo. However, in this aspect as in the other elements of today’s ECB pronouncements, there has been a clear and seemingly successful intention to send signals designed to ensure markets remain calm.
The same efforts to avoid any dramatic negative market reaction were evident in the measured and rather limited comments that Mr Trichet made on the Greek debt crisis. While Mr Trichet forcefully repeated the ECB’s complete opposition to any measures that might threaten a ‘credit event’, he avoided any statements that would emphasise the seemingly intractable differences that divide European policymakers on this critically important issue. It would be helpful if the tone Mr Trichet struck today marked the beginning of an era of ‘verbal discipline’ meaning these vexed issues are debated behind closed doors rather than across the airwaves.
While today’s ECB press conference must be regarded as a very successful holding operation, there remain major hurdles for the ECB and markets to negotiate in the weeks and months ahead. Aside from the ongoing Greek drama and upcoming Eurozone bank stress tests it seems likely that the ECB will need to act to raise rates further later in 2011. On today’s new ECB projections, the ECB’s policy rate would remain negative in ‘real’ or inflation adjusted terms in both 2011 and 2012 even after a further 25 basis point rate rise in July. The ECB is likely to want to return its main policy rate to positive territory in a relatively orderly manner. We previously expected that this would mean further rate increases in September and December but the unravelling of the Greek support programme raises the possibility of just one further rate rise between July and end year. We should emphasise that the likelihood of ECB rates hitting 2% by end year not alone depends on the evolution of the debt crisis but also hugely and unpredictably on the vagaries of summer weather effects on food price trends later this year. While we think that at present markets may significantly underestimate the risk of two additional ECB rate hikes that would bring rates to 2% in late 2011, nonetheless it seems prudent to suggest that level may not be reached until early 2012. In this regard, it would be foolish to disregard the main message from today’s ECB press conference that the nature and extent of the uncertainties in relation to economic and financial outlook for the Eurozone at present argue strongly against definitive statements at this point in time.
Today’s ECB press conference will be generally regarded as very successful in that it prepared the way for an imminent rate rise while defusing fears of a more threatening policy stance later in 2011. That said, we can’t finish without drawing attention to a minor misdemeanor by Mr Trichet that serves to highlight some of the continuing problems in finding the right monetary policy stance for current conditions. Mr Trichet was asked whether a rise in rates would be particularly painful for the peripheral Eurozone economies. He responded that by dampening inflation expectations, this would be good for all countries. While this is an understandable response for the ECB President to make, it is notably less accurate than his usual retort that ECB policy is set only by reference to the Eurozone as a whole. Using inflation data for May, the ‘real’ or inflation adjusted rate ECB rate for Germany is -1.2% while for Ireland it is zero. Given the very different current growth momentum of the two economies, there is little question that a July rate will affect these two countries very differently – even before we take into account the greater sensitivity – of the Irish economy to short term rates. There is little the ECB can do to deal with these problems (in its defence real rates are currently -2% in Greece and -2.2% in Spain). However, as with many other official pronouncements emanating from various European capitals at present, denying problems exist may not be the best course of action.
KBC Bank Ireland PLC,
Sandwith Street,
Dublin 2.
economics.desk@kbc.ie
01 6646000
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