Source; AIB Economic Research

Three Irish Bank Economist on ECB Rate Outlook August 2008: The President of the European Central Bank told a press conference in Frankfurt on Thursday following the decision of the ECB Governing Council to keep the key benchmark rate on hold at 4.25%, the latest economic data point to a weakening of real GDP growth in mid-2008. AIB's John Beggs says a cut in ECB rates cannot be ruled out in 2009 but it would require a marked fall in inflation down towards 2%.

It is now a reasonable assumption that the ECB will keep its benchmark rate on hold for the remainder of 2008. The slowing Eurozone economy or the real possibility of a recession that a number of economists had appeared to hope for to justify their optimistic predictions of rate cuts from early 2008, is now evident in recent economic data. However, as to rate cuts in the first half of 2009, not even the ECB knows what is in store never mind economists. So treat such forecasts with a pinch of salt.

Commentaries from three Irish bank economists on Thursday shows agreement on the interest rate outlook for the remainder of 2008.

John Beggs, Chief Economist, AIB Bank:

The European Central Bank left interest rates on hold at 4.25% at its policy meeting today. This was in line with market expectations, following last month’s 0.25% increase. July’s rate increase, the first since the 0.25% hike seen in June 2007, was in response to what the ECB saw as the growing upside risks to price stability. Inflation is currently at record high levels and is expected to remain elevated for a considerable period.

Mr Trichet pointed out once again at the press conference that the primary goal of the ECB is price stability. Despite the recent fall in oil prices, he defended the July rate hike, stressing that the ECB remains strongly committed to preventing second-round effects materialising from the current elevated inflation readings and also to firmly anchoring inflationary expectations in line with price stability. It is paying “particular attention” to wage deals.

In the run up to the meeting, there continued to be some concern in the market that the ECB could deliver a further rate hike, given that the HICP is now over 2% above target.

Source; AIB Economic Research

However, Mr Trichet adopted a balanced tone and gave no indication that further tightening is in the pipeline.

He cited downside risks to growth in the eurozone, adding that GDP growth for mid 2008 is likely to be substantially weaker than for the first half of the year. The current policy stance was described as contributing to the maintenance of price stability, suggesting a neutral bias.

It should be noted that there has been quite a marked tightening of monetary conditions since last summer. Interbank rates have seen a pronounced rise, with three month EURIBOR 0.70% above where it was this time last year and the twelve month EURIBOR up by 0.80%. Furthermore, there has been a sharp appreciation of the euro over the past year.

There are clear signs that this monetary tightening is impacting on economic growth. All the leading indicators of activity are pointing to a very sharp slowdown in the economy.

The ECB last published forecasts in June that saw it cut its GDP growth forecast for 2009 to 1.5% from 1.8% previously. The projected rate of growth for 2008 is 1.8%. This compares with GDP growth of 2.6% in 2007 and would represent below trend growth for both years. Even these forecasts could prove too optimistic.

The latest PMI readings for both the manufacturing and services sectors point to GDP growth more or less stagnating this summer.

The ECB, then, is facing what could be described as something close to stagflation in the eurozone economy.

This will make it difficult to hike rates any further. Indeed, the HICP rate is likely to fall back next year as the upward pressure eases on food and energy prices. With the economy likely to have weakened considerably over the course of 2008, we could well see the ECB cut interest rates in 2009, provided inflationary pressures abate.

Eurozone Economy Losing Considerable Momentum

Leading eurozone indicators have been in decline since mid-2007, a clear sign that the economy is losing momentum.

Although GDP growth was strong in Q1 at 0.7%, the year-on-year growth rate stood at 2.2%, down from 3.2% a year earlier. Data published since then point to a much more severe deceleration in the pace of activity over the balance of this year and into 2009.

The EC’s economic sentiment indicator fell sharply again in July to 89.5 from 94.9 in June, well down on its May 2007 peak of 111.6. Meanwhile, the manufacturing PMI fell to a three year low of 47.4 in July from 49.2 in June, well below its peak of 57.8 in June 2007. The services PMI eased to 48.3 in July from 49.1 in June, a four year low and well down on the peak of 58.3 a year ago. The composite PMI stood at 47.8 in July, down from 49.3 in June and off its peak of 57.8 a year earlier.

The continuing sharp decline in leading indicators in recent months suggests that growth will weaken much further during the course of 2008.

Indeed, the PMI readings for July are consistent with an economy that is now close to stagnation. If the PMI readings remain below the 50.0 level, it suggests that the economy could grow by less than 1% next year. If the PMIs continue their marked downtrend, the eurozone economy could well hit recession.

Inflation, though, has picked up sharply on the back of soaring food and energy prices, hitting a fresh historic high of 4.1% in July. Despite the signs of a marked weakening in activity and subdued core inflation, the ECB believes that, over the medium term, the risks to price stability are on the upside.

It points to the still historically high level of oil and other commodity prices, as well as possible additional increases in administrative charges and indirect taxes. Furthermore, wage inflation has accelerated. ECB officials also believe that the continuing strong growth rates of monetary and credit aggregates pose another upside risk to price stability.

The ECB’s sole mandate is preserving price stability. However, the tone of today’s press conference reinforces our view that July’s hike was a once-off increase. Any further tightening over the balance of the year seems increasingly unlikely with the economy close to stalling.

The ECB’s task may not prove as difficult next year. Inflation should benefit from a positive basis effect on energy and food prices and as weak growth dampens underlying price pressures in 2009. Thus, the HICP rate should fall sharply next year and could could even decline below 2% by the end 2009. Hence, with the economy likely to be very weak, a cut in ECB rates cannot be ruled out for next year, but it would require a marked fall in inflation, down towards 2%. The crucial factor in this regard will be the evolution of energy and food prices which, ironically, are beyond the control of the ECB and its monetary policy. The tightening of monetary conditions over the past year, though, may also play a role. It has helped drive the economy close to recession, which should in time lead to downward pressure on the core inflation rate.

Source; AIB Economic Research

Simon Barry, Senior Economist, Ulster Bank Capital Markets:

… ECB notes that economic growth in Q2 and Q3 will be “particularly weak”…
…and ECB staff growth forecasts set to be revised down for this year and next…
…but inflation risks still lie to the upside…
…very high rates of actual inflation, vigorous money supply growth and the threat of second-round effects remain of concern to the ECB…
…wage trends and levels of inflation expectations are not providing much comfort…
…but Trichet repeats that he has “no bias”…
…and there was no indication that another hike is being signalled at this stage…
…the chances of further action from the ECB this year haven’t disappeared but continue to fall

Following last month’s 0.25% hike, the ECB left interest rates unchanged today at 4.25% - an outcome that was fully expected by market analysts.

Recent news on economic activity in the euro area has been nothing short of lousy. A host of economic indicators from the Purchasing Managers Indexes (PMIs) of activity in services and manufacturing to measures of business and consumer confidence, to retail sales have all come in weaker than economists have been expecting.

This deterioration in the incoming economic news was a clear theme in today’s post-meeting press conference. Trichet did remind us that there was always going to be payback in Q2 for the very strong 0.7% GDP growth in the first quarter. However, over and above this effect he did acknowledge that recent data point to some materialisation of the downside risks to the growth outlook which the ECB have been flagging for some time. Interestingly and significantly, he said that he expects the second and third quarters to be “particularly weak” and the reference to “moderate ongoing real GDP growth” – the ECB’s central scenario for some time now – was dropped.

We can take it that ECB staff will be revising down their growth forecast when it is updated later this month (and made public at next month’s press conference). The June forecast was pencilling in GDP growth of 1.8% and 1.5% this year and next, but look out for downgrades on both fronts in a month’s time, to around 1.5% and 1.2% respectively, possibly lower.

But despite the weaker economic environment, ECB concerns on the inflation front have certainly not evaporated. In fact, the statement explains that the latest information has “further underpinned the reasoning behind our decision to increase interest rates in July”. Inflation rates are likely to remain above target for a protracted period of time; even accounting for recent declines in oil and other commodity prices, inflation is likely to remain above 3% until the end of Q1 next year. Also, growth in money supply remains vigorous, and the ECB continues to stress the importance of avoiding second round effects in wage and price setting. On this latter point, it is significant that the ECB is now of the view that the “worrying” level of inflation rates is due to both the indirect as well as the direct effects of higher energy and food prices, effectively an admission of the appearance of second-round effects.

Overall and even allowing for the weaker growth dynamic, the risks to the medium-term inflation outlook remain to the upside. Moreover, the statement also emphasised that maintaining price stability in the medium term is the ECB’s primary objective, thus differentiating the ECB from the Fed whose mandate also includes the promotion of sustainable economic growth.

But despite this conclusion, Trichet’s overall tone did not sound aggressively hawkish. For example, he repeated the line from last month that he has “no bias” and there was no indication that another rate hike is being actively contemplated by the ECB at present.

In summary, the ECB continues to fret about high inflation, and with some justification too. Actual inflation is at a record high of 4.1% (amid signs of indirect as well as direct effects of higher food and energy costs), wage trends in the euro zone are not favourable and measures of inflation expectations in the financial markets remain very high. However, the weaker is economic activity, the less will be the need for the ECB to follow up the July hike with further action. Our base case has been that rates would be left on hold this year, with the risks to that view skewed to the upside. Today’s update from the ECB confirms that the ECB is on hold at present. While upside risks to the near-term rate outlook have not disappeared, they continue to diminish.

Austin Hughes, Chief Economist, IIB Bank:

After raising interest rates in early July, the European Central Bank indicated that rates were unlikely to change further anytime soon.  As a result, today’s decision to leave policy rates unchanged was universally expected.  That said, economic conditions have changed significantly in recent weeks.  So, there was significant interest in the tone of ECB President Jean Claude Trichet’s regular monthly press conference.

Since the ECB raised rates on the 3^rd of July, inflation has risenfurther and noises on wage developments have become more threatening. On the other hand, world oil prices have fallen sharply and the news flow from monthly indicators pointed towards sharply weaker Euro area economic activity.  In addition, as the first anniversary of the beginning of money market turmoil is commemorated, there are few signs of a significant easing in the credit crunch while the recent breakdown of world trade talks further adds to uncertainty about global prospects.

Although Mr. Trichet attempted to strike a balance and continued to emphasise that the ECB has no bias in relation to the future direction of interest rate policy, financial markets were clear in their interpretation of his remarks.  In brief, it seems that the ECB has become more concerned about the emerging slowdown in growth.  For this reason, markets priced out previous fears of a further interest rate increase and market sentiment is beginning to contemplate what set of circumstances might bring rates lower even if it should be emphasised that this remains a rather distant prospect.

It is usually although not always the case, that any change in ECB thinking must be gleaned from relatively subtle changes in language.  Today’s press statement underlines that the ECB continues to see upside risks to inflation and Mr. Trichet again emphasised that ‘maintaining price stability… is our primary objective’.  However, the tone of today’s comments on the economic outlook hint at a measure of surprise on the part of the ECB at the speed of deterioration in various indicators of activity in the past month.  Most tellingly, Mr. Trichet admitted in response to a barrage of questioning that ‘(the) data very clearly suggest materialisation of downside growth risks’.  Mr. Trichet didn’t elaborate further and batted off many questions by saying a new set of ECB projections would be available at the early September Governing Council meeting.  It seems likely that the mid-point of ECB forecasts for 2008 and 2009 will fall from the current estimates of 1.8% and 1.5% respectively.  Any reduction may not be particularly dramatic.  While IIB Bank forecasts envisage Eurozone growth of close to 1.5% this year and around 1.2% and possibly lower in 2009, we think revised ECB forecasts might remain somewhat higher. 

Full year economic growth figures may not be the key factor in coming months.  We think there is a decent chance that the Euro area economy will report two consecutive quarters of negative growth in the second and third quarters of this year, thereby meeting with the conventional definition of a recession.  Although the ECB continues to emphasise it’s task of ensuring price stability, it would be a good deal more than embarrassing if the Euro area economy were to slip into recession while the US economy (at least for the moment) continues to post modest growth.  In such circumstances, the contrasting approaches of the respective Central Banks might attract considerable attention. 

We previously suggested that there were likely to be significant differences in thinking among the members of the ECB Governing Council.  Today’s ECB comments hint that the ‘dovish’ wing has become more vocal of late.  They also point to some important points of divergence.  Mr. Trichet was repeatedly asked why weaker growth was not seen to be contributing to a less threatening outlook for inflation.  His answers hints at fairly vigorous discussions within the Governing Council at present.  They also hark back to what lessons from the 1970’s might be relevant today.  Mr. Trichet suggested that the current oil price shock not only leads to weaker economic activity, it also implies weaker potential output (although Mr. Trichet said there has been no formal ECB revision of growth potential estimates).  This comes about because of the transfer of resources from oil consuming to oil providing countries.  In such circumstances, the scope for policy to boost economic activity would be significantly constrained.  Instead, ‘looser’ policy could lead to higher inflation rather than stronger activity and employment.  These considerations may suggest that the ECB is readying it’s responses to what may be a period of notably poorer economic growth between now and end year.

In summary, it would seem that the ECB has been taken by surprise by the speed of slowdown in recent Eurozone economic indicators. Emerging weakness in activity has strengthened the hand of the ‘dovish’ camp within the Governing Council and substantially reduced the threat of a further rate rise in the months ahead.  If oil prices continue to soften and activity weakens further, markets may begin to anticipate an early 2009 rate cut.  However, it is likely that a significant number on the ECB Governing Council continue to see stubbornly high inflation as the dominant threat.  So, the ECB is likely to strongly resist any build-up in optimism that borrowing costs could be set to fall.