* Next rate rise now more likely in July rather than June.
* Delay may reflect tactical and ‘diplomatic’ considerations.
* Uncomfortably high inflation still means rates may rise further than markets expect…
* … But ECB also faces other pressing issues.
* Sovereign debt crisis means monetary policymaking far more problematic.
* ECB in an increasingly difficult position.
The European Central Bank appears to have backed down from a June interest rate increase with the next rate rise now likely to come in July. However, as inflation has moved further above the ECB’s target, further rate rises can be expected through the remainder of this year and into 2012. We continue to think the ECB will raise rates somewhat faster than the market now expects but today’s guidance from Mr Trichet that rates will not rise next month hints that there may be differences of opinion within the Governing Council as to the pace at which rates should rise and also in relation to the risks tightening poses to economic and financial stability within the Eurozone. Mr Trichet said today’s decision not to raise rates was unanimous but he was careful to avoid any direct answer to a question on different views within the Governing Council. Today’s announcement may also something to the substantial complication that the sovereign debt crisis poses for ‘normal’ monetary policymaking.
There are a range of quite different influences that may have argued against raising rates next month. It could be that the ECB feels markets might interpret a June rate rise as pointing towards a significant acceleration in the likely pace of tightening in the Eurozone. That would stand in marked contrast to the policy position now being adopted by both the Fed and the Bank of England and the ECB may be concerned that a step-up in rate expectations would prompt a surge in the Euro and notably increased rate expectations. To an extent such a judgement had already become evident in foreign exchange markets of late as the Euro come under sustained upward pressure. The significant weakening of the Euro in the aftermath of Mr Trichet’s pronouncements today testifies to the sensitivity of markets to small
differences in the outlook for ECB policy.
A further consideration is that the ECB might have seemed to be reacting to the recent rise in inflation in a very mechanistic fashion if it were to pre-announce a June rate rise and this could be misinterpreted to suggest very aggressive rate action would be taken if commodity prices were to rise further. Yet another argument is that as Mr Trichet suggested in April that the ECB hadn’t decided on a sequence of rate increases, a preannouncement of an imminent rate move. Just a month later might raise questions about Mr Trichet’s capacity to control the more hawkish members of the ECB’s Governing Council.
Arguably of greater significance, the perception that the ECB was set on an aggressive course of action could carry significant risks given current market worries about the sustainability of debt and growth trajectories of a number of peripheral Eurozone economies. So, today’s announcement may reflect a desire to tread carefully during a particularly delicate period when agreement on Portugal’s assistance programme is being finalised, doubts about Greece have increased sharply and there is mounting criticism of the ECBs role in Ireland’s decision to seek assistance last November.
For a variety of reasons, some of which are of its own making, the ECB now finds itself in a very difficult position. From the Autumn of 2009, the ECB was very public in its criticism of Greek fiscal policy and also took a high profile note in the various machinations that culminated in the Greek assistance deal last May. To a significant extent, this reflects the ECB’s extraordinary position as the main supra-national policymaker within the Eurozone but it could also be argued that a Central Bank that guards its independence so strongly might have been better to provide its opinion and technical assistance on non-monetary policy issues behind closed doors. Importantly, Mr Trichet’s obvious annoyance at repeated questioning on the possibility of debt restructuring during today’s press conference may reflect growing opposition to the ECB’s trenchant position on this vexed and critically important topic.
Judged from this perspective, today’s decision to delay an almost inevitable rate rise may owe quite a lot to the ECB’s deep involvement in policy issues that are not immediately related to its primary goal of price stability. In this context, it may be significant that the ECB decided to remind us of its key mandate in today’s statement; “Maintaining price stability over the medium term is our guiding principle, which we
apply when assessing new information, forming our judgements and deciding on any further adjustment of the accommodative stance of monetary policy.” It is noteworthy not only that they feel the need to introduce this reminder of their principal raison d’etre but also because this paragraph appeared just before one in which the ECB lays out typically forthright views on fiscal policy noting that “there is a risk that, in some countries, fiscal balances may fall behind the targets agreed by the ECOFIN Council for the necessary and timely correction of excessive deficits. It is essential that all governments meet the fiscal balance targets for 2011 that they have announced. Where necessary, additional corrective measures must be implemented swiftly to ensure progress in achieving fiscal sustainability. The implementation of credible policies is crucial in view of ongoing financial market pressures.” These insertions into today’s statement remind us of the difficulties that the ECB may face in concentrating all its energies on ‘normal’ monetary policy issues at present.
Another somewhat related complication is evident from comments Mr Trichet repeated a couple of times today that there has been a further improvement in the functioning of the money markets in the Eurozone. If this is the case, it should mean that the ECB is moving closer to a further scaling back of its exceptional liquidity support. However, strangely, Mr Trichet said that today’s Governing Council meeting didn’t discuss the ECB’s liquidity framework. This seems to suggest that the ECB still remains some distance from arriving at a satisfactory solution to the problem of a number of banks structural dependence on its emergency funding.
Again, these apparent inconsistencies highlight the dilemma the ECB faces. These considerations suggest a wide range of reasons why the ECB might have decided to play safe today and hint that rates are likely to rise in July rather than June. These reasons range from the tactical to the diplomatic. However, with inflation set to remain uncomfortably high in coming months, the pressure for tighter policy is set to build. For this reason, we continue to look for 3 further rate hikes in 2011.
That said, the timing of future increases now becomes slightly more complicated. To follow a rate rise in July with a further increase in September might appear hasty although it would coincide with new ECB economic projections. A further rate rise in October rather than September is certainly possible although that might be seen as an unfortunate way to mark Jean Claude Trichet’s last meeting as ECB president. Similarly, a November rate rise might not make for an auspicious start for Mr Trichet’s successor who seems likely to be Mario Draghi, the current Bank of Italy Governor. In these circumstances markets could remain uncertain about the precise timing and extent of future ECB rate increases for some time to come.