ECB Rate Hike Gun is Locked and Loaded

April 6, 2011

Since the March policy meeting five weeks ago, ECB officials have painstakingly prepared markets for a rate hike on April 7, which presumably will be 25 basis points in size.  The statement released last month used all the coded expressions that generally precede an increases.  Comments by officials subsequently have backed up the initial signals, including President Trichet’s remarks on March 21st that he had nothing to add to what the statement and his press conference responses had implied.

Euro zone data released since the March meeting also support a decision to begin normalizing rates.

  • CPI inflation accelerated to 2.6% in March from 2.4% in February, 1.4% in March 2010, and 0.6% in March 2009.  It averaged 1.9% per annum in the seven years between March 2003 and March 2010, which was spot on target.  2.6% now is significantly above target.
  • Producer prices rose 0.8% on month and 6.6% on year in February and at a 12.7% annualized rate over the last three reported months.
  • Price components of purchasing manager survey data indicated intensifying pressure at the input and output levels of distribution.
  • The retail purchasing managers index in March was 53.5, rebounding from February’s 49.9 and exceeding the 4Q average of 51.0.
  • The services PMI improved to 57.2 from 56.8 in February and averaged 57.9 in 1Q after 55.4 in 4Q.
  • The composite PMI points to Euroland growth of 0.7-0.8% in 1Q, more than twice as fast as seen in 4Q10.
  • Industrial production in January was 1.0% higher than the 4Q10 average level.
  • Economic sentiment printed at 107.9 in February but 107.3 in March (affected by Japan’s disaster and elevated oil costs).  The March level was 3.9 points higher than six months earlier.
  • Money and credit growth have each moved above zero and show signs of continuing to trend upward.

Although a refinancing rate increase to 1.25% will create no surprise, the move will be controversial.  Portugal, Greece and Ireland seem to be on a rendezvous with a destiny of default, and ECB tightening will aggravate strains making that outcome increasingly likely.  President Trichet has repeatedly rebutted complaints about the disparate growth trends in the common currency area with the analogy of the United States where the Fed pursues a one-size-fits-all policy for states with widely different circumstances.  His metaphor breaks down on closer examination.  There are 50 states in the United States, all of whose sovereignty is subordinate to the Federal Government’s.  The two states with the biggest GDP levels, California and Texas, have a 13.3% and 7.9% share of U.S. GDP, a combined total of 21.3%.  45 of 50 states have GDP shares of less than 4.0%.  In contrast, Germany (27.3%) and France (20.4%), which happen to be the two economies badly in need of tighter monetary policy, have a combined 47.7% of euro area GDP.  This level of concentration is so much greater than found among U.S. states as to render Trichet’s point cute but inapplicable.

Analysts hoping to find clues in what Trichet says tomorrow should take such with a grain of salt.  In December 2005 when the ECB began to raise rates in the previous tightening cycle, the move had been verbally teed up in advance just like now, and it was greeted with concern that the Euroland recovery wasn’t sufficiently developed to handle higher interest rates.  Nowadays, Trichet loves to remind his audience that the central bank, and not private analysts, had assessed the economic scene correctly then, that in fact regional recovery became much better grounded during 2006, and that officials by acting on their conscience had averted a problem of second-order inflation.  What Trichet doesn’t mention is what he said at that press conference in the way of guidance regarding future policy.  He repeatedly reiterated that officials did not mean to engage in a “series of rate hikes” and that the Council would continue to monitor medium-term inflation prospects and act accordingly as data require.  That was December 2005.  The ECB went on to implement rate hikes, all by 25 basis points, in March 2006, June 2006, August 2006, October 2006, December 2006, March 2007, June 2007, and July 2008. 

What does it really mean to not commit to multiple interest rate increases?  The future cannot be foretold with 100% certainty, so of course circumstances can change.  We saw that when Islamic terrorists bombed the World Trade Center, when Lehman Brothers collapsed, and just last month when Japan was victimized by the triple disaster of the worst earthquake in 100 years followed by a tsunami that surpassed the expectations built into the country’s renown sea walls and which then caused the most serious nuclear power accident since Chernobyl.  These were game-changing events, and usually something that extreme doesn’t occur.  Barring a comparable surprise, a rate increase from 1.0% to 1.25% is not going to prevent second-order inflation given the magnitude of the commodity price shock.  When the 23-person Governing Council votes to raise rates on Thursday, it will be the overwhelming expectation of the members that other similar tightenings will be needed to accomplish the mission.  Having had a 1.0% refinancing rate for the past 23 months, it will not suffice to space the increases out at six-month intervals.  The regional economy simply will not respond to such marginal change.  It’s duplicitous for officials to imply otherwise and that this might be an isolated one-time action.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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