Source: AIB Economic Research
ECB Rate Outlook: On Thursday, European Central Bank President Jean-Claude Trichet confirmed that the Governing Council had agreed to keep the ECB's benchmark interest rate on hold at 4%.
Also on Thursday, the Bank of Iceland raised its benchmark rate to 15.5%.
Eaten bread is soon forgotten but the other small open economy on the periphery of Europe - Ireland - is indeed lucky to be within the protective embrace of the Eurozone, in these turbulent times.
Central bank independence is another key aspect of the modern economy that is taken for granted but a return to a manipulation of both fiscal and monetary policy by politicians, would not be a recipe for prosperity.
The ECB's mandate is to provide price stability and in March, inflation rose to a 16-year high of 3.5%, above its target – an annual rate “below but close” to 2%.
Prices and wages are “stickier” – or slower to change – in the Eurozone than they are in the US. Annual inflation is actually higher in the US than it is in the Eurozone, at 4%. Collective bargaining remains widespread in Europe and between one-third and a half of wage contracts are linked in some form to past inflation rates, raising fears of a wage-price spiral or as ECB President Jean-Claude Trichet puts it: "second-round effects."
Consumer prices in the US, Europe and other rich countries are projected to rise 2.6% this year, the highest inflation rate since 1995, the International Monetary Fund said on Wednesday. The IMF forecasts consumer prices in emerging and developing countries will rise 7.4% this year, the most inflation since 2001.
In China, inflation is at an 11-year high and the waning of the co-called China Effect, which resulted in falling import prices of goods from Asia, over two decades, coupled with the commodity boom, suggests that the era of benign inflation is over. The price of rice, the staple for billions of Asians, is up 147% over the past year. Oil is up 79%.
"Overall, the effects of globalization have ceased -- probably in the long term -- to be spontaneously disinflationary," Christian Noyer, Governor of the Bank of France, said last month.
"It's hard to reverse inflation expectations once they've risen,"Kenneth Rogoff, a Harvard University professor and former chief IMF economist said to The Wall Street Journal.
On the ECB rate outlook, John Beggs of AIB forecasts that the central bank will make two cuts in 2008 starting in September. Simon Barry of Ulster Bank says that the ECB benchmark will remained unchanged at 4% into 2009.
John Beggs, Chief Economist at AIB says:We expect that the ECB will be more comfortable about easing policy later this year as data confirm a further slowing in activity and inflation pressures begin to ease. However, rate cuts may amount to no more than 50bps given the upside risks to price stability and expectations that inflation will remain above 2% for quite some time.
Simon Barry, Senior Economist at Ulster Bank says: Overall, the ECB’s stance is not much changed and we maintain our long-held view that the ECB will leave rates on hold this year...We note that market expectations have shifted strongly in this direction over the past month or two, with just one full 0.25% cut now expected by the markets by year-end in contrast to position in mid-March at which point the markets were expecting 3 to 4 cuts.
Austin Hughes, Chief Economist of IIB Bank, long the über-optimist on the Irish economy is still awaiting the Eurozone economy to crash and says that the ECB will "be forced into a summer cut," i.e in June and will make two further cuts in 2008.
Hughes and his counterpart at Bank of Ireland Dan McLaughlin had forecast two ECB rate cuts in the first half of 2008. Last month, McLaughlin retained the number of cuts prediction but removed the timeline.
Austin Hughes predicts that "a painful slowdown will emerge in coming months,"which will force the ECB to shred its credibility and make an emergency cut.
It may well be a case of halitosis of the intellect or more mundanely, pandering to a narrow business audience - - mortgage brokers!
JOHN BEGGS, CHIEF ECONOMIST, AIB - ECB HOLDS FIRM
The European Central Bank again left interest rates unchanged at its policy meeting today. The decision to leave rates on hold at 4% was expected and means that rates now have been unchanged since June 2007. The continuing difficulties in financial markets, marked appreciation of the euro and slowdown in economic activity have taken policy tightening off the agenda, but high inflation and risks to price stability have ruled out rate cuts. Hence, the ECB has no policy bias at the present time.
The primary goal of the ECB, though, is price stability and Mr Trichet again emphasised this point at his press conference today. He indicated that upside risks to the outlook for price stability remain. He also stressed that the ECB is strongly committed to preventing second-round effects materialising from the current elevated inflation readings, following the recent upward spike in the HICP rate to 3.5% from below 2% last summer.
Source: AIB Economic Research
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. Some concern has been expressed at recent wage deals agreed in Germany that will see workers get pay rises of around 8% over the two year period 2008-2009. The ECB’s latest inflation forecasts, though, see HICP (Harminized Index of Consumer Prices) inflation falling back to average 2.1% next year.
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 did say today that he “deplores excessive volatility” in exchange rates. His main message, though, was that
ECB rates remain very much on hold at 4%.
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%.
Given the current high level of inflation, it is understandable that the ECB is not in any mood at present to contemplate policy easing. Furthermore, while the economy has slowed, activity is holding up reasonably well and GDP growth in Q1 could well match the 0.4% rate achieved in Q4, helped by a solid performance by the German economy in particular.
Nonetheless, the continuing downtrend in leading activity indicators suggests that growth will move further below trend as the year progresses. Inflation is also likely to ease later in the year provided that oil and food prices do not continue on an upward trajectory. 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 given the upside risks to price stability.
GDP GROWTH SLOWS BUT INFLATION SPIKES EVEN HIGHER
Leading eurozone indicators have weakened considerably since mid-2007, a clear sign that the economy has lost momentum. Both the ESI (Economic Sentiment Index) and PMI (Purchasing Managers' Index) surveys have continued their downtrend in recent months, reflecting in particular marked declines in the services sector. The EC’s economic sentiment indicator has fallen sharply, hitting 99.6 in March, well down on its peak of 111.6 in May 2007. Meanwhile, the composite PMI for services and manufacturing fell to 51.8 in March, well below its peak of 57.8 last June.
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 0.7% in Q3. GDP growth decelerated to 2.2% year-on-year in Q4 2007 from 3.2% in Q1 of the year. It is likely that the eurozone economy grew by around 0.4% again in Q1 2008. Consumer spending contracted by 0.1% in Q4 2007 and seems to have remained weak in Q1 2008.
The continuing decline in leading indicators in the opening months of the year suggests that growth will weaken even further during 2008. The composite PMI reading of 51.8 in March is consistent with GDP growth of about 0.3%. We think that eurozone GDP growth could average just above 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 also 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, and recent pay deals in Germany, averaging 4% per annum for 2008 and 2009, may cause it some concerns.
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 11.4% year-on-year in February on a three month moving average basis. Meanwhile,
the growth in private sector credit is running at 12.5 % y-o-y. On top of this, the HICP rate continues to accelerate, reaching 3.5% in March, its highest level since the inception of the euro. Rising oil and food prices are the main causes. Food price inflation has surged
from 2.4% to 5.8% year-on-year since September. Energy price inflation, meanwhile, is running at 10.4% 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 data confirm a further slowing in activity and inflation pressures begin to ease. However, rate cuts may amount to no more than 50bps given the upside risks to price stability and expectations that inflation will remain above 2% for quite some time.
Source: AIB Economic Research
SIMON BARRY, SENIOR ECONOMIST, CORPORATE MARKETS - ULSTER BANK
ECB leaves rates unchanged again at 4%
Inflation set to remain above 2% for another 18 months…
…and price risks ‘clearly’ to the upside
Trichet played down the impact of financial market turmoil…
…and highlighted the economy’s sound fundamentals…
…he also distanced the ECB from the approach of the Fed…
…so still no signs of any rate cut on the way
Euro retreats from record highs as Trichet expresses concern about “recent excessive moves” on currency markets
There was no surprise at today’s decision by the ECB to leave official interest rates in the euro zone at 4%, the level at which they have been maintained since June of last year.
Indeed, ECB President Trichet confirmed in the post meeting press conference that broad thrust of the ECB’s policy stance has not changed materially over the past month. It remains the ECB’s view that while the risks to the outlook for economic growth lie to the downside, the risks to the inflation outlook are ‘clearly’ to the upside, with the addition of the adjective ‘clearly’ a modest firming of the ECB’s conviction on this front relative to last month.
Trichet highlighted the persistence of much higher than desirable inflation, noting that “we are experiencing a rather protracted period of temporarily high annual rates of inflation”. This was a reference to the extremely high level of inflation which currently stands at 3.5%, an all-time high for the ECB. However, Trichet’s claim that this is a temporary phenomenon is a bit of a stretch. Inflation has been above 2% since last September and according to Trichet himself is expected to moderate only gradually over the course of this year and is not likely to get back to 2% until about 18 months time. If correct, this would mean that inflation will have been above the target of ‘close to but below 2%' for a cumulative two years - hardly a temporary blip.
Regarding the ongoing turmoil in the financial markets, Trichet noted that such tensions may last longer than initially expected and that this was resulting in “unusually high” uncertainty about the future outlook and represented one source of downside risk to the prospects for economic growth. However, Trichet sought to emphasise that there were no significant signs of households and non-financial corporations having difficulty in getting bank loans, thus appearing to play down the impact of the credit tightening on the real economy thus far. In fact, somewhat strangely, Trichet claimed that he was no more worried now about the turmoil in the markets than he was when it kicked off last August. We suspect that many market participants, not to mention many CEOs of major financial institutions, might have a slightly different perspective on that issue!
On the economy, he noted that the latest indications were consistent with moderate but ongoing growth. He referenced the supportive influences of a resilient world economy and strong growth in emerging economies in particular, as well as the very low levels of unemployment, sustained profitability and high levels of capacity utilisation. He went to some lengths in the Q&A session to differentiate both the euro area economy from the US, as well as the objective of the ECB from those of the Fed. He reiterated that the fundamentals of the euro area economy are sound, and in particular, that the euro area does not suffer from major imbalances, implicitly a contrast with the US with its still-large current account deficit, for example. Trichet was also at pains to remind us that the ECB has but a single objective - price stability - again drawing a contrast with the Fed which has the dual mandate of promoting both price stability and sustainable economic growth. His pointed discussion of such differences was no doubt aimed at defending the ECB’s steady-hand approach, in contrast to that of the hyper-active Fed which, in fairness, has been facing a much weaker US economy.
Finally, Trichet was unusually vocal on recent developments in the currency markets. He said that he “deplored” excess volatility in foreign exchange markets and that he was “concerned by recent excessive moves” adding that recent volatility in the Euro/Sterling exchange rate was not welcome. It remains to be seen whether this concern will result in anything more than such 'verbal intervention'. However, his comments may make traders wary of pushing the single currency much higher ahead of this weekend’s G7 meeting in Washington. Indeed, the euro has retreated somewhat this afternoon having hit record levels against both sterling and the dollar earlier today, of over $1.59 and over 80p respectively.
Overall, the ECB’s stance is not much changed and we maintain our long-held view that the ECB will leave rates on hold this year.
We note that market expectations have shifted strongly in this direction over the past month or two, with just one full 0.25% cut now expected by the markets by year-end in contrast to position in mid-March at which point the markets were expecting 3 to 4 cuts. We acknowledge, as we have done for some time, that the risks to our interest rate view lie to the downside, stemming largely from the possibility of more severe and protracted weakness in the US economy and the potential for a bigger impact from financial market turmoil. However, in the absence of indications of a sharp slowdown in the euro area economy or of much of an impact from credit tightening, the ECB’s concerns about inflation prospects do not give it the leeway to consider a reduction in interest rates at present.
AUSTIN HUGHES, CHIEF ECONOMIST, IIB BANK:
Trichet’s comments broadly similar to those of early March
ECB says inflation still ‘temporarily high’…
.. and ‘economic fundamentals solid’.
So, ECB sees no need to follow rate cuts of other Central Banks.
Trichet does acknowledge greater threat from financial market turbulence.
So, policy on hold for next few months, but…
We think ECB will be forced into a summer cut and expect interest rates will be 75 basis points lower by year end.
Today’s decision by the European Central Bank to leave it’s key interest rates unchanged was almost universally expected. However, there was some uncertainty as to precisely what message would emerge from ECB President Jean Claude Trichet’s monthly press conference. In February Mr. Trichet appeared to strike a dovish tone which fuelled expectations of lower ECB rates by mid-year. In early March, however, Mr. Trichet adopted a notably tougher tone which has caused markets to virtually abandon hopes for a significant easing any time in 2008. Indeed, as we describe in the final section of this note, Mr. Trichet’s March press conference contributed to a substantial rise in market interest rates and in the exchange rate of the Euro, implying a marked tightening in financial conditions facing Euro area businesses in the past month. Continuing strains in credit markets and the Euro hitting new lifetime highs against both the Dollar and Sterling in the past twenty-four hours made for a difficult backdrop to today’s press conference. So, the key question was whether Mr. Trichet would continue to talk tough or whether he would attempt a more nuanced approach. In the event Mr. Trichet said little dramatically new. So, markets still see little prospect of a rate cut anytime soon. We think events could force the ECB’s hand.
Mr. Trichet’s comments today were very similar to those of a month ago. So, it might seem that the ECB’s assessment of prospects both for inflation and activity have changed little in the past month. In reality, a largely unchanged commentary likely reflects the broadly offsetting influence of some significant developments in the shape of poorer inflation data on one side and increased credit market concerns on the other. Judged from this perspective, the limited changes in the press statement hint at an attempt to balance concerns about the further increase in Eurozone inflation in March against the risk that market turbulence ‘could last longer than initially expected’ and increase the threat to the real economy.
If ECB policy is on hold it is not an entirely comfortable position for the ECB. The first paragraph of today’s statement contains a new and interesting, if slightly awkward, sentence; ‘in fact, we are experiencing a rather protracted period of temporarily high annual rates of inflation resulting mainly from increases in energy and food prices.’ This acknowledges the recent deterioration but attempts to downplay it’s importance for policy purposes both by suggesting it to be ‘temporary’ and by emphasising the role played by food and energy prices, elements that aren’t readily available to ECB policy. On the other hand, the ECB is also continuing to downplay the risks to Eurozone economic activity from slower global growth and strained financial markets. In this context, Euro area growth is expected to be ‘moderate but ongoing’. By repeating the phrase ‘we believe that the current monetary stance will contribute to achieving our objective’ the ECB is continuing to emphasize it’s intention to keep policy unchanged for the foreseeable future. It is also trying to signal that it is in a very different situation to the US Federal Reserve or the Bank of England, both of whom are in rate cutting mode.
There is little doubt that there is unanimous agreement within the ECB Governing Council that policy should not change anytime soon. Equally we think there is also considerable divergence as to what is likely to happen beyond the timeframe of the next two or three months. Clearly, inflation remains uncomfortably high and expectations of an early improvement have faded as commodity prices show no clear signs of weakening. With the headline pay increases in recent German wage deals also troublesome even if the underlying deals are less threatening, there appears little scope for the ECB to signal an ‘all clear’ on inflation that might resurrect market hopes for lower rates in the near term. While Euro area headline inflation is awful at present, we are encouraged by the lack of any marked second round effectson ‘core’ inflation from outsized increases in energy and food costs. In part, this reflects the restraining influence of weaker economic conditions and a rising exchange rate which impose a greater need for competitive pricing. While continuing upward pressure on commodity prices creates a degree of uncertainty, we would be hopeful that headline inflation will ease slightly in April. Although we are unlikely to see dramatic easing unless commodity prices tumble,there should be a gradual decline in headline inflation to around 2.3% by end year. At that point, the likelihood of subdued activity levels, (providing that there are no further increases in commodity prices), should imply that inflation will be in line with the ECB’s price stability goal in 2009 and 2010.
On this analysis, it would appear that we might not be too far from a turning point on inflation. However, it is easy to understand why the ECB has to consider a much nastier alternative, the possibility that higher commodity prices could spill over into poorer ‘core’ inflation. Such fears justify the hawkish rhetoric of ECB officials of late. However, if, as we suspect, ‘second round’ inflation threats do not materialise, the ECB could be in a position to contemplate rate cuts as early as its June policy meeting if broader evidence of a deterioration in economic activity suggests the need for such a course of action.
The case for early rate cuts has been undermined by signs of sustained strength in some Eurozone economic data of late. Both the ECB and financial markets are likely to have been surprised by the extent of resilience in activity indicators in recent months. To a significant degree, this reflects particular strength in German production and a weather related boost to Construction. However, as today’s release of solid French output data for February shows, there is still no compelling evidence of a dramatic downturn. We reckon clearer evidence of a notably poorer trajectory for activity will materialise in the next couple of months. For the ECB to ease two conditions must be in place(i) scope for a rate cut in the shape of a clear easing in inflationthat is likely to be sustained and (ii) justification for a rate cut in the form of notably poorer activity data.
While the experience of the past two months suggests financial markets were much too ambitious in anticipating speedy rate cuts, the risk now is that sentiment has moved too far in the opposite direction. One reason why we are reluctant to abandon completely our call for a June ECB rate cut just yet is that there has been a particularly sharp increase in a range of negative forces acting on the Euro area economy of late. The step-down in the US and UK economies around the turn of the year is only now beginning to hit Euro area order books. In addition, the hawkish line taken by Mr. Trichet and other ECB officials during March contributed in no small way to a sharp tightening in Eurozone monetary conditions in the past month. Since the early March ECB press conference, the trade weighted value of the Euro has risen by near 2½%, equivalent to an ECB rate rise of around 30 basis points. In the same period, the cost of 3 month money has risen by roughly 35 basis points while 5 year corporate bond yields have risen by a broadly similar amount. So, the past month has seen an exceptionally sharp increase in the borrowing and currency costs facing Eurozone business. Indeed, as the graph below indicates, the overall tightening in monetary conditions in the past month has been much more severe than in any month since the ECB began tightening at the end of 2005. With this additional restraint imposed on a weakening business climate, we think clearer evidence of a painful slowdown will emerge in coming months. As a result, we think the ECB may still be forced to cut rates, perhaps as early as June. Even if the initial move is delayed a little longer, we still think the key ECB interest rate should fall by 75 basis points to 3.25% by end year.