Markets Conclude ECB Back to Wait-and-See Mode After 25-bp Rate Hike

July 3, 2008

The ECB raised key rates for the first time since June 2007.  The 25-basis point increase of the refinancing rate to 4.25% matched expectations had had been strongly hinted at the June ECB press conference.  However, ECB President Trichet did not present today’s move as the first of a series of increases.  On the contrary, he explicitly said that the Bank has no rate bias from the new policy stance.  He did not reiterate the claim that officials are in a state of heightened alertness, nor did he use the word “vigilance,” which in the past has signaled a readiness to raise rates at the next meeting.  Since the ECB had not previously raised rates in consecutive months during the current cycle of increasing restraint, I would not read too much into these omissions.  Officials never try to convey the impression of mapping out multiple future policy changes. What does catch my eye, however, is the omission of a promise to “act in a firm and timely manner” in the future to preserve medium-term price stability.  That pledge was contained in the June 2008 statement and, more importantly, in the June 2007 statement.  The last prior rate hike had occurred in June 2007, so the statement then was made under analogous circumstances to today.

Today’s formal statement underscores to a greater-than-usual degree that a decision to raise rates is enshrined in law.  “in full accordance with our mandate, we emphasize that maintaining price stability in the medium term is our primary objective.”  The word “mandate” is an allusion to the Maastricht Treaty that created the ECB and euro and would not have been mentioned if Bank officials had not anticipated some political opposition to today’s action.  Regarding inflation, the claims are made that upside risks are “increasing” and that above-target readings will persist “for a more protracted period than previously thought.”  Regarding economic growth, ECB officials are less optimistic about the outlook for real disposable incomes and personal consumption, which are being squeezed by higher energy and food prices, but their view on overall growth prospects remains essentially the same.  They are looking at 1H08, not 2Q08, growth.  The trend is still one of moderating growth even when the first and second quarter are averaged, but officials  predicted and in fact required a moderation to sub-trend growth in order to restore acceptable medium-term inflation and thereby sustain long-term growth.  Commodity market pressures have eclipsed ongoing financial market tensions as the main risk for less-than-projected growth.  Comments by monetary officials about money and credit growth remain the same, namely that such “confirm the prevailing upside risks to price stability at medium to longer-term horizons.”

Trichet’s frequent mention of price expectations has led many analysts to conclude that indications of expected inflation are a third pillar guiding monetary policy, along with growth and price trends and money and credit trends.  Trichet spoke of expected inflation today as something to be avoided at all cost.  The rate hike is intended as a preventive measure.  He did not say that that price expectations are becoming less well anchored.  That suggests a willingness to let some time pass while data can be monitored before even considering a rate hike.  One variable among many that is being examined is the euro’s performance.

Slower growth will not be a sufficient condition to establish 4.25% as the cyclical peak in rates.  Even if officials revised expected growth lower, I would expect another rate increase sometime if inflation and/or expected inflation accelerate discernibly from present levels.  In stagflation, which Trichet rejected as a label for the present world economy, accelerating inflation coexists with decelerating growth.  Given that choice, the ECB will address the inflation problem.  But it will take time and data evidence to convince the ECB Governing Council that a 4.25% refinancing rate no longer represents an appropriate stance.



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