- Higher inflation and solid growth momentum,
- point to further normalization of policy,
- no new info on ECB liquidity provision via full allotment, but....
- widening of interest rate band is possible,
- silence on the issue of the debt sustainabilty of peripheral countries ...
- hides an ever more uncomfortable relationship with governments.
Recent inflation and economic developments are likely to convince the ECB that it has to tighten monetary policy again in the near term. So, our expectation that they may act by June has increased. To keep this prospect intact, Mr. Trichet will likely drop the expression that the ECB will monitor developments very closely and use instead the expression “strong vigilance”. These words would open the door to a further rate hike in June. Our ECB view is very much based on the way the ECB acted in the early stages of the previous tightening cycle, including the use of code words to signal its intentions.
In this note, we start by summarizing the essence of last month’s meeting, paint the relevant developments since and conclude by our expectations for the monetary policy decision and briefly touch on the non-conventional policies of liquidity providing and government bond buying.
In April, the European Central Bank increased its key policy rates by 25 basis points to bring its refinancing rate to 1.25%. This was the first interest rate increase since July 2008 and while Mr Trichet indicated that the ECB “did not decide that this was the first in a series”, his qualification that “we always do what we judge necessary” and that “the ECB will monitor very closely” meant to our view the ECB aimed for a normalization of policy. In such a context, a one off rate increase from 1% to 1.25% obviously didn’t sit well.
Furthermore, at the April meeting the ECB judged that the stance of monetary policy remained “very accommodative” and gave no indication that rates were after the rate increase “appropriate”. Instead, the ECB saw “risks to inflation remain on the upside” and the risks to activity “remain broadly balanced”.
Inflation runs further away from target
Inflation has deteriorated further of late as HICP inflation increased to 2.8% in April according to the flash estimate. In March, it was 2.7%. The full details of the inflation report will only be available when the final HICP report is published later this month, but partial national data suggest that the inflation increase was driven by increases in core items. While the ECB targets headline and not core inflation (no energy and food), the ECB may see it as vindicating their controversial view that core CPI trends tend to follow headline CPI and not the other way around. This is also the reason why the ECB targets headline inflation.
Stronger euro eases impact
Oil/energy prices were still substantially higher on average in April compared to March, but the rise of the euro compensated for a large part of that increase. So, energy might have played less of a role in the increase of inflation in April. From the ECB point of view, a stronger euro at this stage is preferable. Fighting inflation that has a large oil/commodity element is more effective through a stronger currency than via higher rates which tend to have a greater effect on domestic prices. For some peripheral countries, a tightening via the currency is preferable above higher rates. Several peripheral countries have mortgage rates linked to short term rates and are thus very sensible to higher ECB rates, while the extra-EMU trading of Southern peripherals is relatively less important. (In contrast, the exchange rate is important to the Irish economy.) Of course, a rising exchange rate doesn’t mean the ECB will stop increasing rates, as the euro would doubtless weaken again if rate hikes were delayed. Some ECB governors understandably downplayed recent euro strength, but unease may grow if the pace of currency strengthening continues to accelerate. We are interested to hear whether Trichet makes some reference to the euro’s strength, although we think it is too early for euro strength to play a decisive role in policy decisions.
Two extra remarks need to be made on inflation and its impact on ECB policy. Firstly, as Jürgen Stark - the ECB Chief Economist - and several other council members have recently highlighted, unchanged policy rates at a time of rising inflation makes policy even more accommodative. Given that the inflation rate jumped by 0.2%-point in March and another 0.1%-point in April, the first 25 bps. rise in the ECBs refinancing rate hasn’t materially altered the ‘real’ interest rate, which is the economically important variable when judging the stance of policy. Comparing the 1.25% refi-rate to the 2.8% inflation rate gives a negative real rate of 1.55%, little changed from the -1.70% trough in March. Mr. Stark said recently that monetary policy had become more accommodative despite the recovery. We think that comparing actual inflation to the current refi-rate on a month to month basis is a bit arbitrary. Being forward looking, economic agents should compare the refirate with expected inflation, but this wouldn’t radically change the conclusion in the current circumstances. In March the ECB staff projections put inflation at 2.3% in 2010 and at 1.7% in 2011. Even the latter is still well above the 1.25% refi-rate. In June, the ECB will have the new inflation projections. There is little doubt that the 2010 and 2011 inflation estimates will be revised higher, something the ECB cannot pass unnoticed. In this context the ECB Council will also have a new survey from its external forecasters panel at this week’s Governing Council Meeting. These inflation forecasts are also likely to show a sharp jump compared to three months ago. Higher inflation forecasts are an important argument we put forward to justify our expectation for a June rate increase.
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