|Source: AIB Economic Research
European Central Bank President Jean-Claude Trichet on Thursday gave a clear signal that the ECB's benchmark interest rate currently at 4% will not be cut in the coming three months at least. Only the delusional could believe otherwise.
Before exploring views on the ECB rate outlook, it is well to keep in mind that nobody knows what the benchmark rate will be in December 2008. Jean-Claude Trichet doesn't know and any amount of parsing by wishful thinkers doesn't change that fact.
To have a rate cut in the second quarter would require a dramatic deterioration in the Eurozone economy or a collapse in the US dollar. China could take a big loss on selling billions of dollars for euros and alienate a key trading partner and so on. At the level of pub-stool economics, any scenario is possible.
What is very interesting but unsurprising, is that the economists who are the über-optimists on the Irish economy are the über-pessimists on the Eurozone. Put simply, a rate cut is seen as a big potential boost for the Irish housing market even if a recession in the Eurozone triggers it. Be careful what you wish for as the Chinese proverb says.
|Source: AIB Economic Research
Last week, Bloomberg reported that financial markets have it wrong: Jean-Claude Trichet isn't about to cut interest rates, according to the Merrill Lynch & Co. economist who defied conventional wisdom by correctly predicting the European Central Bank president's course two years ago.
Klaus Baader, Merrill's London-based chief European economist, said he doesn't expect Trichet to lower borrowing costs this year. His view, shared by economists at Goldman Sachs Group Inc., ABN Amro Holding NV and Morgan Stanley.
Also last week, Dan McLaughlin, Chief Economist of Bank of Ireland said that the ECB will make two rate cuts in the second quarter i.e. on June 5th, the benchmark rate will be cut to 3.5%.
On Thursday in a commentary on the Trichet's press conference, Austin Hughes, Chief Economist of IIB Bank said: "...we expect the ECB will cut rates by June. However, it is not too difficult to envisage circumstances in which the ECB could be forced to cut somewhat sooner if financial market conditions continue to deteriorate and/or economic indicators confirm a notably poorer trend than the ECB now anticipates.Reflecting our more pessimistic view on the outlook for activity, we also feel the ECB may be compelled to cut rates by as much as 75 basis points by end year."
Simon Barry, Senior Economist at Ulster Bank Capital Markets said: "Our base case remains that the ECB will leave rates unchanged this year. Based on today's update, it looks as if it would take indications of a sharp weakening in the economy to get the ECB to soften its stance on the inflation outlook."
John Beggs, Chief Economist of AIB Bank said:"..we believe that the ECB will be able to ease policy later this year. However, rate cuts may amount to no more than 50bps in 2008 given the upside risks to price stability."
Both Bank of Ireland's Dan McLaughlin and IIB Bank's Austin Hughes, had called a peak of 3.5% when the ECB was tightening monetary policy. But for the onset of the credit crisis the benchmark rate would have been raised to 4.25% in September 2007.
John Beggs, Chief Economist AIB Bank:
ECB VERY MUCH ON HOLD
The European Central Bank again left interest rates unchanged at its policy meeting today
for the ninth consecutive month. The decision to leave rates on hold at 4% was expected. The continuing difficult financial markets, marked appreciation of the euro and slowdown in economic activity rule out policy tightening, but high inflation and risks to price stability rule out rate cuts at present. Hence,the ECB has no policy bias at the moment.
The primary goal of the ECB is price stability and Mr Trichet again pointed this out at his press conference today. He stressed that upside risks to the outlook for price stability remain and that the ECB remains committed to preventing second-round effects materialising from the current elevated inflation readings, following the recent upward spike in the HICP rate to 3.2%.
The ECB expects that the current rise in inflation will prove temporary. However, Trichet has warned that, for this to be the case, it is essential that price and wage setting behaviour remains unaffected by the present high rate of inflation.
The ECB's new quarterly inflation forecasts, published today, see HICP inflation averaging 2.9% in 2008, falling to a still above target 2.1% next year. This represents a marked upward revision to the previous HICP forecasts made in December of 2.5% for 2008 and 1.8% for 2009.
Mr Trichet did also emphasise the downside risks to economic growth. Indeed, the ECB revised down significantly its GDP growth projections made last December, from 2.0% in 2008 and 2.1% in 2009 to 1.7% and 1.8%, respectively. This is below trend growth and well down on the 2.6% rise in GDP recorded last year. The weakening growth outlook has been the key factor in taking policy tightening off the agenda, despite rising inflationary pressures.
Of course, there has been an effective further tightening of policy since last summer via a rise in interbank rates and the marked appreciation of the euro.
Mr Trichet had little to say today about the renewed rise of the euro and decline of the dollar. His main message was that rate cuts are unlikely to materialise anytime soon. It should be borne in mind that 4% is not an exceptionally high level for ECB rates, especially when compared to the level that official rates reached in most Anglo-Saxon economies last year. Indeed, official interest rates continue to be hiked in a number of countries, including ones where rates are already well above 4%.
Overall, given the ECB's inflation forecasts, it is understandable that the ECB is not in any mood at present to contemplate policy easing.
Nonetheless, the marked decline in leading activity indicators suggests that growth will be well below trend this year. Inflation is also likely to ease later in the year provided that oil and food prices do not continue on an upward trajectory.
The EC's economic sentiment indicator has fallen sharply, hitting 100.1 in February, well down on its peak of 111.6 in May 2007. Meanwhile, the composite PMI for services and manufacturing fell to an average of 52 in January/February, well below its peak of 57.8 last June. Both the ESI and PMI surveys regis
Thus, we believe that the ECB will be able to ease policy later this year. However, rate cuts may amount to no more than 50bps in 2008 given the upside risks to price stability.
Leading eurozone indicators have weakened considerably since mid-2007, a clear sign that the economy is losing momentum.
tered marked declines for the services sector in particular in the first two months of 2008.
The weakening trend in leading activity indicators has been borne out by real economy data.
GDP growth slowed to 0.4% in Q4 2007 from 0.8% in Q3. Both consumer spending and government expenditure contracted by 0.1% in the quarter, while xport growth slowed appreciably. GDP growth decelerated to 2.2% year-on-year in Q4 2007 from 3.1% in Q1 of the year.
The ongoing decline in leading indicators in the opening months of 2008 suggests that growth will weaken even further in 2008. The composite PMI reading of 52 for Jan/Feb is consistent with GDP growth of about 0.3% in Q1. We think that eurozone GDP growth could average just 1.5% this year.
However, despite the signs of a marked weakening in activity, the ECB believes that over the medium term, the risks to inflation are on the upside. It points to the marked uptrend in oil and other commodity prices and possible additional increases in administrative charges and indirect taxes. Wage inflation may accelerate given the continuing positive trends in the labour market and high capacity utilisation. The eurozone jobless rate has fallen steadily to 7.1%. Hence, the current wage round is being closely watched by the ECB.
ECB officials also believe that the continued strong growth rates of monetary and credit aggregates pose another upside risk to price stability. The growth in M3 money supply stood at 11.8% year-on-year in January on a three month moving average basis. Meanwhile, the growth in private sector credit is running at 12.7 % y-o-y.
On top of this, the HICP rate has accelerated sharply to 3.2% in the opening two months of 2008, its highest level since the inception of the euro. Rising oil and food prices are the main factors. Food price inflation has more than doubled from 2.4% to 5.4% year-on-year since September. Energy price inflation, meanwhile, is running at 10.6% y-o-y.
However, the ECB knows that well below trend growth is probably the surest way of squeezing inflationary pressures out of the economy.
We expect that the ECB will be more comfortable about easing policy later this year as official data confirm a marked slowdown in activity and inflation pressures begin to ease. However, rate cuts may amount to no more than 50bps in 2008 given the upside risks to price stability and expectations that inflation will remain high for quite some time, as indicated by the new ECB forecasts.
|Source: AIB Economic Research
Simon Barry, Senior Economist - Associate Director Corporate Markets, Ulster Bank Group:
ECB LEAVES RATES ON HOLD AT 4% AS EXPECTED…
The latest ECB projections show that growth forecasts for '08 and '09 have been revised lower…
…but the inflation forecasts have been revised significantly higher…
…inflation this year is expected to post a record overshoot of 2.9%...
…and the ECB is also likely to miss its target in '09 – the 10th consecutive year of overshoot…
…Trichet played down expectations for lower rates…
...so the ECB is on hold…
…and expectations for multiple rate cuts this year remain vulnerable to disappointment
The ECB left euro zone interest rates unchanged at 4% today, as expected.
The latest ECB staff projections, an important input into the Governing Council's thinking, show that the forecasts for GDP growth have been revised down for this year and next, to 1.7% and 1.8% respectively (from 2.0 and 2.1% respectively in December). These outcomes were broadly in line with prior expectations in the market and reflect the impact of the global slowdown, the tightening of credit conditions and the effects of higher commodity prices on spending power.
However, arguably of greater importance was the fact that the forecasts for inflation have been marked up significantly, and by more than had been expected by market observers, in part reflecting the increases in food and energy prices in recent months.
The latest forecast (as per the mid-point of the presented range) for average inflation in 2008 now stands and 2.9%, considerably higher than the 2.5% pencilled in last December. And underlining the deterioration in the inflation outlook was the forecast for inflation in 2009 which now stands at 2.1%, up from 1.8% last time.
Thus, the forecast envisages that inflation will again overshoot the ECB's target of “close to but below 2%” in both 2008 and 2009, taking the run of consecutive overshoots to a staggering 10 years.
So despite an acknowledgement that economic growth is moderating, the inflation outlook remains highly problematic for the ECB, with Trichet reiterating that the risks to the inflation outlook remain to the upside and emphasising the importance of preventing second-round effects.
Trichet revealed in the question and answer session that the decision to leave rates unchanged was unanimous, with no calls within the Governing Council for either raising or decreasing rates. It was interesting that despite the acknowledgement of the likelihood that growth would be sub-trend for the next couple of years there was no-one looking to cut rates at today's meeting. We take this as support for our long-held view that it would take more than a period of growth just a bit below trend to get the ECB to abandon its concerns on the inflation front.
Trichet was pressed on prevailing expectations in financial markets for rate cuts later this year, and he took the opportunity to say that the ECB was “not underwriting market rate expectations”, thus distancing himself from the notion that the ECB may be about to embark on a cycle of rate cuts.
Overall, the ECB remains very much on hold, with a softer and highly uncertain growth outlook offset by concerns about the strength of inflation pressures. Our base case remains that the ECB will leave rates unchanged this year. Based on today's update, it looks as if it would take indications of a sharp weakening in the economy to get the ECB to soften its stance on the inflation outlook. While such a weakening cannot be entirely ruled out in the current environment, expectations for multiple rate cuts this year remain vulnerable to disappointment.
Austin Hughes, Chief Economist, IIB Bank:
ECB DOWNPLAYS CHANCE OF EARLY RATE CUTS
ECB suggests it is not planning to change policy anytime soon.
Worries about inflation and easing of growth fears mean Trichet sounds less dovish than a month ago.
We still expect rates to fall by 75 basis points by end year.
Soaring Euro, impact of weak US economy and strains in Spain and Italy will force the ECB's hand.
We now expect first rate cut in June but wouldn't rule out earlier move if financial conditions deteriorate or activity data disappoint.
The European Central Bank has kept it's key policy rate unchanged at 4.00% for the ninth successive month. Mr. Trichet, the ECB President, used his regular monthly press conference today to suggest that the ECB does not intend to alter policy anytime in the near future. In this regard, his main purpose was to deflate market hopes for any near term cut in interest rates.
Mr. Trichet emphasised that the ECB's focus remains firmly on ensuring price stability. Eurozone inflation remained at it's record level of 3.2% for a second month in February, some considerable distance above the ECB's target. So, it will take compelling evidence of a sharp deterioration in Eurozone economic conditions (that would bear down on inflation) before the ECB feels sufficiently comfortable to contemplate reducing rates.
In the wake of Mr. Trichet's comments today, financial markets take the view that circumstances should change sufficiently to allow the ECB cut rates once in the Summer and again before the end of 2008.We believe that clearer evidence of a sharp weakening of activity and an associated improvement in the inflation outlook should materialise in the next couple of months. As a result, we think the ECB might be forced to cut rates somewhat earlier than the market now envisages. Our expectation that notably poorer economic conditions will develop in the next few months also implies the ECB may have to cut rates as many as three times by the end of the year.
What Trichet Said
Probably the key change in the tone of today's press conference from a month ago was that Mr. Trichet made a determined effort to downplay concerns that the Euro area economy is set to experience a marked deterioration of the sort now being suffered by it's US counterpart. In this regard,the first paragraph of today's press statement no longer includes any reference to ‘downside risks' to economic activity. Instead it simply re-iterates that ‘the fundamentals of the Euro area are sound' – presumably this is an attempt to emphasize the contrast with problems the US economy faces in relation to it's housing market and balance of payments.
The ECB goes on to say that ‘incoming macroeconomic data point to moderating but ongoing real GDP growth'. Again, the tone of this sentence is markedly different, and intentionally so, to yesterday's Federal Reserve Beige Book which indicated that (US) ‘… economic growth has slowed since the beginning of the year. Two thirds of the Districts cited softening or weakening in the pace of business activity, while the others referred to subdued, slow or modest growth.' Mr. Trichet spoke today of ‘different Central Banks in different universes'.
Clearly, the ECB and Fed are oceans apart in their assessment of current conditions in their respective economies. To an extent this reflects a significant difference in the scale of downturn in economic conditions between the two zones. However, it also underscores a difference in policy signals. The Fed is emphasising the process of reducing US official rates will continue at it's March 18th policy meeting. (The ECB sought to emphasise today that with a further substantial cut, probably of 50 basis points) it is not ready to contemplate beginning the process of reducing interest rates in the Euro area.
The subtle but very important shift in the tone of today's ECB press conference likely reflects the influence of two factors. First of all, Eurozone inflation has remained stubbornly high of late and the combination of record commodity prices and a worrying German wage round have increased the likelihood that inflation will remain higher for longer than expected. Second, the ECB were probably heartened by signs of resilience in a range of Euro area indicators in the past month. At the margin, the risk of a possibly severe slowdown that was suggested by Euro area purchasing managers data for January and the information coming from the US economy in early February may have caused some at the ECB to fear an imminent and pronounced deterioration in Eurozone economic conditions a month ago. However, in the interim, a significant rebound in February PMI services data together with resilient readings from the IFO and a number of other surveys seem to have lessened such fears. Although the ECB still acknowledges that risks to activity lie to the downside, this threat appears far less immediate than a month ago.
What do new ECB projections tell us?
The ECB has reduced it's forecasts for economic growth and raised it's forecasts for inflation both for 2008 and 2009. Inflation is now seen sharply higher at 2.9% in 2008 (previously 2.5%) and somewhat higher in 2009 at 2.1% rather than 1.8%. While the upward revision to the 2009 projection is slightly larger, the rise in the 2009 estimate is more significant. First of all, it implies the ECB sees no significant unwinding of inflation next year even as a result of favourable base effects. Second, the fact that the 2009 outturn remains above the ECB's definition of price stability to the end of the (published) policy horizon emphasises that in the ECB's judgement inflation risks remain to the upside.
Of course, it should be emphasised that today's projections effectively assume that the ECB cuts its policy interest rate to 3.25%. So, the ECB's projection that inflation would remain above target in such circumstances is consistent with the ECB's concern that cutting interest rates sharply in coming months would not be appropriate. In this sense, the projection is a technical representation of Mr. Trichet's comments today that ‘we do not underwrite future market interest rates.' That said, he stopped some distance short of rubbishing market expectations entirely by adding that the ECB never precommits. It should also be noted that if lower interest rates mean inflation might be higher than the ECB would want, a failure to cut rates also means economic growth would be lower than today's ECB projections envisage.
Although today's projections underscore the ECB's reluctance to countenance early rate cuts, the reality is that circumstances are changing rapidly and in a manner that makes projections outdated very quickly. For example, the ECB projections assume the Euro will average $1.47 in 2008 and $1.46 in 2009. They also assume oil prices will average $90.6 and $89.1 in these two years. Given how dated these now appear, it would be very surprising if the assumptions underlying today's projections remain valid for any length of time.
We continue to expect lower interest rates
In summary, today's ECB press conference should be seen as a determined effort to prevent excessive hopes for an early cut in interest rates. We reckon stubbornly high inflation and less activity troubling data in the past month have made the ECB more resistant to any notion of an early easing in policy. However, the reality is that Central Banks rarely if ever prepare a ‘glide path' when the interest rate cycle is about to turn downwards. The statement the US Federal Reserve released after it's August 7th meeting last year warned that the Fed's ‘predominant policy concern remains the risk that inflation will fail to moderate as expected'. Within a very short time it's words and actions emphasised a very different agenda. We don't think the ECB wants to cut rates now and we don't think it envisages cutting anytime soon but our long-term characterisation has always been of ‘a bumpy path to lower rates' in the Euro area.
In spite of the apparent resilience in some recent indicators, we think a trend towards markedly weaker economic growth in the Euro area is now becoming established. A recent worsening in financial market conditions will add to these pressures. We also note the particular strength of the Euro on FX markets and the rather lame reliance by Mr. Trichet on empty utterances from US policymakers that they favour a ‘strong' Dollar. In reality, the authorities in Washington are glad of the support a declining currency gives to American exports. So, provided there is no adverse feedback from a weaker currency to the price of US assets, a policy of ‘polite' neglect towards the Dollar will persist. However,the impact of the Euro regularly breaching record highs against the Dollar and Sterling should quickly become painful for Eurozone companies that export or compete with imports. Finally, we think signs of particular strains in the economies of Spain and Italy that together account for around 30% of the Eurozone economy will lead to a clear weakening in Euro area activity in coming months.
Because we also see Eurozone inflation easing as early as March data become available,we expect the ECB will cut rates by June. However, it is not too difficult to envisage circumstances in which the ECB could be forced to cut somewhat sooner if financial market conditions continue to deteriorate and/or economic indicators confirm a notably poorer trend than the ECB now anticipates. Reflecting our more pessimistic view on the outlook for activity, we also feel the ECB may be compelled to cut rates by as much as 75 basis points by end year.