ECB Warns of Possible Rate Hike in 3Q08

June 5, 2008

Today’s ECB statement and press conference were the most hawkish since last August. The decision not to raise rates was not reached easily. There was no consideration of reducing them, and some council members argued either for tightening policy now or very soon. In this non-unanimous discussion, not everyone felt that current rates are appropriate. In May, by contrast, nobody had urged doing either a rate hike or cut on the group. The language used to describe growth prospects was not more dovish as some market analysts anticipated such would be, while inflation was characterized in a number of phraseology changes as much worse.

No fewer than four changes appear early in the statement to prepare markets for the possibility of a rate hike. Most importantly, the formal statement said the Council is “in a state of heightened alertness.” This is a term used before in verbal remarks but not the Bank’s written statement. In Q&A, Trichet seemed to ascribe specific meaning to the use of this expression. Whereas the term “high vigilance” in the past has implied a strong likelihood of a rate hike at the next meeting unless dramatic developments occur to abort that intent, “heightened alertness” seems to convey a possibility but not a guarantee of a rate increase at the next meeting. The other four modifications to text say 1) risks to price stability over the medium term have increased further, 2) observing no significant constraints on bank loan supply, 3) and adding “strong determination” to the the intent “to secure a firm anchoring of medium- and long-term inflation expectations in line with price stability.”

Projected GDP growth in 2008 has been revised to 1.5-2.1% from 1.3-2.1%. For 2009, the new quarterly forecast was lowered to 1.0-2.0% from 1.3-2.3% because of the drag of higher commodity prices. However, officials underscored the point that the trough in economic momentum will be reached later in 2008, not in 2009. Bottom line is that growth is expected to be satisfactory and perhaps even too ample in light of high inflation. The statement from May had said CPI inflation would likely remain “significantly above 2% in the coming months, moderating only gradually over the course of 2008,” whereas today’s statement warns that it “is likely to remain above 3% for some time to come, before moderating only gradually in 2009.” That is a huge qualitative change between two successive months and is backed up by the staff’s new inflation forecasts. The CPI in 2008 is forecast in a range of 3.2-3.6%, up 0.6 percentage points (ppts) from a forecast in March. Earlier forecasts had anticipated 1.5-2.5% last September and 2.0-3.0% made last December. The 2009 forecast was revised up 0.3 ppts to 1.8-3.0%, thus centered a half-ppt above the target ceiling, and Trichet in Q&A felt that a return to in-target inflation remained 18-24 months away. Similar to the May statement, the Governing Council devoted a whole paragraph to the urgent need for responsible wage and price setting-behavior and to how such constitutes a pre-conditions for the highest priority of securing “that medium to longer-term inflation expectations remain firmly anchored in line with price stability.

Without Bernanke’s extraordinary dollar-supportive remarks earlier this week, it would have been very hard for ECB officials to have taken such a tough enough-is-enough stand against inflation. As it is, the euro rallied against the dollar by as much as 1.2% from a low of $1.5366 to $1.5560 on a day that also saw Germany report a surprise 1.8% decline in April industrial orders. Given that ECB officials have been shocked by the upsurge of inflation but unfazed by growth trends that are consistent with their expectations, the decision not to raise rates today shows considerable restraint. Moreover, the reason for revising growth next year lower was higher inflation, so one doesn’t boost growth in response by cutting interest rates and aggravating the inflation problem still further. I suspect ECB officials are not merely grandstanding. Decision-making dynamics on the Council for a rate hike in July should be taken very seriously. New highs in the euro or a serious financial market setback could delay the decision, but I doubt that a batch of weak data would do so if those other problems do not also worsen.



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