ECB Preview: Looking for Clues to How Soon Easing Might Begin

September 3, 2008

It is only two months since the ECB hiked its refinancing rate by 25 basis points to 4.25%.  With Euroland likely to have entered a recession in the second quarter, that increase has drawn considerable debate.  Some approve the move, others are very critical, and many want to see it reversed before yearend.  Seven months separated the final rate hike in October 2000 and the first cut of the ensuing ease cycle in May 2001.  The comparable intervals between tightening and easing of the final three policy cycles at the Bundesbank were 9 months, 6.5 months, and 15 months.  That’s not big sample for establishing a precedent, but unfortunately monetary policy cycles cover many years apiece, and there have been only four peaks since 1981.  ECB officials have resisted private-sector speculation about a near-term rate cut, even while conceding that growth has weakened more than anticipated.  Several monetary officials have warned that a slowdown in growth will not necessarily lead to a sufficient reduction in inflation.  Trust but verify.  A majority of policymakers may now trust the likelihood of falling inflation not to boost rates additionally as a precautionary move, but they will want to verify that price pressures and expected inflation have indeed crested before sanctioning a rate reduction.  The policy status quo will unquestionably be maintained this month.

The August press conference was more dovish than expected, and the key at Thursday’s briefing will be how much more bearish officials are about growth and/or more confident they have become about long-term inflation prospects.  Information can be conveyed in two ways: verbal signals and the release of new quarterly growth and price projections.  At one extreme, a buzzword could emerge to signal a fairly imminent easing, which would play a similar role to the V-for-vigilance word used when policy was getting tightened.  I believe such code will come to the fore.  Investors do not have specific phrases to watch for since Trichet has not yet presided over an easing cycle.  A reduction in October just three months after the July hike would break past patterns and therefore looks doubtful, although not impossible.  Discussion about the business cycle tomorrow will be more guarded than in August, and projected growth in 2008 and 2009 will be scaled back.  In June, officials projected growth of 1.5 – 2.1% this year, a revision from 1.3-2.1% made in March and 1.8 – 2.8% made in September 2007.  The June 2008 forecast for growth in 2009 was 1.0 – 2.0%, and even the 1.0% floor now looks perhaps too high.

Weaker growth ought in time to contain core inflation, and that restraint plus lower energy costs would reduce total inflation.  But in the meantime, officials like Juergen Stark have said that second-order inflation may already be starting to take root.  One sees that happening in accelerated wage demands from Germany’s I.G. Metall and other unions.  Italy has so much wage indexation that no active decision is required to pass on higher commodity-induced price pressures.  It happens automatically.  The ECB has to err more than the Fed against stopping inflation quickly because wage indexation is much more prevalent in Europe than the United States.  A year ago in September 2007, the ECB staff released a forecast of 1.5 – 2.5% CPI inflation in 2008, giving even odds that such would be within target versus above such.  This past June, the CPI forecast for 2009 was 1.8 – 3.0%, almost entirely above the 1.9% target ceiling, and the new estimate will likely be a band that does completely surpass the bank’s goal.  Justifying a rate cut while forecasting that inflation almost certainly exceeds target not only this year but next year too makes a rate reduction unlikely within a month or two.  The key to whether the ECB eases before end-2008 therefore lies not so much in how weakly growth prospects are painted but in how that weakness is seen expediting the process of restoring acceptable inflation and re-anchoring expected inflation.

The announcement of no change in target rates will be made at 11:45 GMT, and a press conference to unveil the new forecasts and explain the latest thinking of officials will begin at 12:30 GMT on Thursday.



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