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| European Central Bank President Jean-Claude Trichet (l) and Deutsche Bundesbank President Prof. Axel Weber.
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Bank of Ireland's Dan McLaughlin, who as recently as last month was forecasting two ECB - European Central Bank - rate cuts in the second half of 2008, has reversed course and now accepts that the bank is set to raise its benchmark rate to 4.25% on July 3rd.
While the majority of European forecasters were predicting ECB rate cuts in 2008, economists at Ulster Bank did not expect cuts in 2008 while as recently as April, Austin Hughes of IIB Bank - a bank that is mainly dependent on property financing - was forecasting 3 cuts with the first one in June. According to Thursday's Irish Independent, Hughes now expects two ECB rate rises in 2008.
At the core of the disconnect between market expectations and declared ECB intentions was viewed as the bank's failure to emerge from the shadow of the US Federal Reserve.
"Markets tend to put a very high correlation on Fed interest rates and European interest rates," said Klaus Baader, Chief Europe Economist at Merrill Lynch last March and one of a minority of European bank watchers who said he believed the ECB would keep rates steady all year. "That was the case when European monetary policy was driven by the Bundesbank and it is true now."
The Fed cut the Federal funds rate to 2% in April.
In September 2007, Finfacts reported on a dinner to celebrate the 50th anniversary of the German Bundesbank, at which Jean-Claude Trichet said: "With regard to the Bundesbank, I think that it is fair to say that its foundation provided not only Europe but also the rest of the world with a very good example, and indeed a role model, of central banking.
The trademarks of this role model are monetary stability, independence and credibility. The Bundesbank has embodied them from its inception, and, today, they are recognised all over the world as essential for monetary policy to deliver price stability and, in this way, to support sustained economic growth and job creation."
He also said that the clear objective of price stability and the independence from executive branches, however, were not the only necessary conditions for the success of the Bundesbank as an institution. The additional and decisive condition has been the credibility it gained with the German people and with global financial markets. Credibility is not something that can be installed by decree, it has to be earned, Trichet said.
It should have been clear, even before the recent super spike in oil prices, that barring a serious economic slowdown, the ECB was not going to cut rates from early 2008 as was forecast from September 2007, when the Fed began its series of aggressive cuts.
Oil the key driver of rate outlook according to Bank of Ireland
“Last September inflation in the euro area was 2.1%, having climbed above the ECB’s target for the first time in a year. Energy, which accounts for some 10% of the total price index, had risen by 3% over the previous twelve months, but since then the annual inflation rate in energy has surged to 13.7%. Food prices (accounting for some 16% of the index) have also risen sharply, from an annual rate of 2.4% to 6.4%, and these two categories have been the key drivers in pulling the euro zone annual inflation rate up to the current 3.7%”, according to Bank of Ireland’s June Bulletin (June issue had not been uploaded on the BoI server at the time we posted our report) which was published today.
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Bank of Ireland's Chief Economist Dan McLaughlin |
Commenting, Dan McLaughlin, Chief Economist, Bank of Ireland and author of the Bulletin said: “This acceleration has proved a move too far for some members of the ECB Governing Council, and it seems that the Bank is set to raise rates by a quarter of a percent in July, contrary to our and most of the market’s expectation that the next move would be down. Indeed, the market has now switched to fully pricing in a half point rise in rates by year-end. Higher rates will not affect inflation in the short-term, but the rationale is that it will help to anchor inflation expectations and convince firms and households that the ECB will do all it can to bring inflation back to the target. The proposed rate-rise occurs against a backdrop of slowing economic activity, (the latest PMI index implies that the euro zone had negative growth in June), which should eventually lead to a fall in inflation, but the ECB Governing Council appears unwilling to wait for this to happen”.
Concluding McLaughlin said: “In truth, consumer’s expectations of inflation probably owe more to their recent experience of inflation, particularly high frequency purchases such as food and energy, than to Central Bank monetary policy. In that sense the near-term path of oil prices will prove decisive in determining headline inflation, expectations and hence ECB policy. Crude oil has risen by over 35% in the past few months, having doubled in 2007 in dollar terms, and if it stabilises at current levels inflation in the euro area is likely to fall steadily from September, helped by positive base effects from food, albeit with a strong risk that it creeps higher near-term.
Should this scenario unfold, or if oil prices fall, the ECB may limit its tightening to a quarter point. A further acceleration in oil prices and further spike in headline inflation may mean even tighter policy, however, even though the resultant slowdown would be such that the ECB would probably end up cutting rates aggressively in 2009. The short term outlook is therefore unclear, but with rates now unlikely to fall this year as we expected the euro may end the year around $1.50 instead of the $1.40 we had forecast”.
