- They may call it something else but ‘normalization’ of monetary policy will continue…
- …as the ECB is keen to apply its separation principle…
- Showing that nothing will distract the ECB from its main policy goal.
- …However, acting tough means Trichet needn’t talk tough during the press conference…
- In the hope that both markets and the ECB will be able to enjoy a well deserved quiet holiday
The ECB raised its inflation alert at the June Governing Council policy meeting to “strong vigilance”. In the past this was the clear signal that interest rates would be raised at the next meeting, even though the ECB repeatedly emphasises that it never pre-commits.
This disclaimer, which never prevented the ECB from raising rates when they suggested they would do so, has attracted more attention in recent weeks. As the Greek crisis threatened to move to a full-blown financial crisis markets recognised that the ECB might be obliged to set its principles aside and postpone the signalled rate increase.
After some worrying movements, financial markets’ tensions eased last week when the Greek parliament approved a medium term fiscal stability programme containing far-reaching austerity measures and an ambitious privatisation programme. This opens the door to the disbursement of the €12B tranche of the EU/IMF rescue loan and to a new three-year rescue package. With near term risks diminishing, the ECB seems set to increase rates on Thursday by 25 basis points to 1.5%. However, we don’t expect the ECB to give any guidance on future moves.
Economic picture deteriorates while inflation eases
If, as we expect, the ECB wants to normalize its policy even though Mr Trichet seems to dislike this particular phrase, the current economic and inflation picture won’t have an overwhelming impact on policy decisions, only a marginal one. Therefore, the current slowing of growth and the slight decline of current inflation and inflation expectations do not provide sufficient arguments to call off the intended rate hike.
In a speech before the EU parliament last week, Mr. Trichet explained why a rate hike was likely. He repeated the ECB’s assessment of a positive underlying momentum of economic activity in the euro area” and said the ECB sees “the continued expansion of the world economy and domestic demand from the private sector as the main factor of growth in the euro area.” The ECB continues to observe upward pressures on prices especially in the earlier stages of the production process, while inflation is also likely to remain clearly above the ECB’s 2% limit for many months ahead, due mainly to energy and commodity prices.
However, the “true” reasoning behind the ECB policy is often better articulated by ECB board members, like Mr. Stark and Mr. Bini Smaghi. Both explained again recently that negative real rates can’t be justified for long, as these make monetary policy overly accommodative now that the euro area (as a whole) is recovering. That’s also the reason why we stick to our view that the ECB in a first phase of its tightening cycle aims to bring the refi-rate to 2%, the ECB inflation target (ceiling). As inflation may stay above 2% until the end of the year, 2 more 25bps points rate increase are likely with about a 3 month interval, which would allow the ECB to reach its initial target around the turn of the year. Thereafter, the ECB may pause, to allow the opportunity to assess the impact of its policy on the economic situation and outlook. The ECB may also take into account that the Fed most likely won’t have started its tightening cycle and running too far ahead of the Fed is not without dangers given the particular sensitivity of currency markets.
Separation principle confirmed
The ECB is proud of its separation principle according to which it uses its interest rate policy for fulfilling its main objective - price stability, while it uses its liquidity policy to support malfunctioning financial markets. By raising rates but at the same time keeping its liquidity policy under a Full allotment/Fixed rate procedure, the ECB will again confirm this principle this week. Because the ECB prolonged its exceptional liquidity policy for another 3 months at the June meeting we don’t expect announcements on this subject.
In an interview with Les Echos, Mr. Bini Smaghi said that the ECB is working on establishing funding plans for Greek, Irish and Portuguese banks to complete the reduction of their financial leverage. The measures must be gradual enough to avoid credit contraction and contain firm deadlines to reduce their dependence on the Eurosystem, Bini Smaghi added. This is of course a very important issue that could have serious implications for ECB liquidity policy overall and a profound impact on the situation of the banking system of the peripheral countries. It is unlikely though that the ECB will communicate to any meaningful degree on what is still ‘work in progress’.
Press conference to be boring?
The ECB will be happy to show via a rate hike that it is still fully concentrated on fulfilling its mandate of price stability. On the other hand, the ECB may see benefits in keeping a lower profile on other issues and in sounding neutral on further monetary steps it may take. Therefore, the objective of Mr. Trichet in the press conference will be to avoid more uncertainty and volatility in markets. Privately, the ECB certainly hopes that markets will calm down during summer if nothing else than to give the ECB some needed respite after many hectic months. Indeed, the ECB has been far too often in the picture recently on issues that don’t strictly fall under their authority, like the Greek debt crisis. In addition, the ECB sometimes caused unnecessary volatility on issues that are within their authority, like the threat to stop accepting Greek collateral in case of default caused by the re-profiling or rollover of its debt. So, we expect to see an ECB chairman at the press conference who is in holiday mood and who will circumvent, in his well-known able manner, all difficult questions of the journalists.
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