ECB Policy Meeting Preview

July 2, 2008

The ECB will announce an increase of its policy rates, including a 4.0% refinancing rate, at 11:45 GMT on Thursday and foreshadow likely policy in 2H08 at a press conference beginning at 12:30 GMT.  This will be the first rate increase in 13 months.  All eight increases between December 2005 and June 2007 were by 25 basis points.  Rate changes affect future inflation with a lag of 18-24 months.  Officials seek total consumer price inflation of “below but close to 2.0%.”  Such is presently at 4.0%, over twice this target.  Producer price inflation, a gauge of upstream price pressures, has risen to 7.1% from 4.4% at the end of 2007.  While energy has been the main impetus for this acceleration, non-energy producer prices accelerated from 3.2% at end-2007 to 3.8% now, so energy and food inflation seems to be spreading to the broader economy.

Economic activity is in the meantime slowing.  Many analysts foresee a sharper slowdown than ECB officials have predicted.  Stagflation presents a smaller dilemma for the ECB than Fed, because its mandate is limited to price stability.  Changes in the outlook for growth guide policy only to the extent that such modifies the outlook for inflation.  Officials are under no obligation to fine-tune policy to influence growth per se in the shorter-to-medium term.  In fact, just the opposite can happen.  If weak growth encourages politicians to complain about excessively tight monetary policy, ECB officials may have to dig in their heels to demonstrate their independence and safeguard their credibility.  The fact that inflation is now too high suggests that ECB officials raised rates too slowly in 2006.

Analysts universally expect this week’s rate hike to be by 25 basis points, and an increasing number of them believe this will be the only remaining advance.  I think 25 bps is the most probable size of increase for two reasons.  Foremost, officials didn’t prepare markets for the possibility of a larger increase.  Central bankers like to avoid surprises if possible.  Secondly, officials would be wary that a surprise 50-bp increase might lift the overvalued euro above resistance levels to a new record high and beyond.  Some members of the ECB Governing Council likely would prefer a bigger move than 25 bps, because evidence has arisen of some upward movement in expected inflation, which is to be avoided at all cost.

I also think it is premature to pronounce this month’s rate hike as the last one.  I think such a scenario only happens if oil and other commodity prices fall.  It’s not just a question of demand in Europe slowing substantially, growth in emerging markets would need to slow significantly as well, since their demand for resources had been driving commodity markets.  The ECB will not move in consecutive months, however, so the coast will be clear until at least September.  If commodity prices level off, that in theory would be enough to reduce inflation.  But after a long run-up, a flat trend in energy would not be a stable equilibrium.  Either prices will keep climbing, or they will go into a downward correction.  But I am getting ahead.  The tone of ECB President Trichet’s remarks on Thursday will be that rising inflation presents a greater present threat than declining growth and that a restoration of price stability is the best contribution the central bank could make toward ensuring ample and sustainable medium-term economic growth.  Trichet will remind us that the Governing Council takes policy one step at a time and does not pre-decide future policy changes, which are data dependent.

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