ECB Signals Likelihood of a Much Sooner-Than-Expected Rate Increase

March 3, 2011

While proclaiming that the ECB Governing Council never pre-commits to a future interest rate change, President Trichet used code language to suggest a major likelihood of a rate increase in April. He

  1. Said “strong vigilance is warranted with a view to containing upside risks to price stability.”
  2. Failed to say current rate levels including the 1.0% refinancing rate “are appropriate.”
  3. Called present monetary policy “very accommodate” rather than “accommodative” as he’d done in February.
  4. Shifted the medium-term price risk assessment from “broadly balanced” to being “on the upside.”
  5. Replaced the prior growth risk assessment of “slightly tilted to the downside” with a view that they are now “broadly balanced.”
  6. Proclaimed that a rise of inflation has occurred since the last monthly meeting even though expected inflation remains firmly anchored.
  7. Revised projected inflation in 2012 to a range centered on 1.7% from a midpoint of 1.5% and the projected inflation midpoint in 2011 to an above-target 2.3% from 1.8%, which was right in line with the target.
  8. Also revised projected GDP growth higher (see table below whose dates represent sequential forecast modifications).
  GDP 2011 GDP 2012 CPI 2011 CPI 2012
03/11 +1.3/2.1% +0.8/2.8% +2.0/2.6% +1.0/2.4%
12/10 +0.7/2.1% +0.6/2.8% +1.3/2.3% +0.7/2.3%
09/10 +0.5/2.3%   +1.2/2.2%  
06/10 +0.2/2.2%   +0.2/2.2%  
03/10 +0.5/2.5%   +0.9/2.1%  
12/09 +0.2/2.2%   +0.8/2.0%  


A rate increase had not previously been expected from the ECB before June, and the modal consensus appeared to be looking for a September timing.  The language used in today’s statement, especially the expression “strong vigilance is warranted” was used repeatedly during the last ECB tightening cycle in meetings that took place one month before actual rate hikes were implemented.  ECB officials had to know that investors and analysts would assume from today’s statement that the central bank will raise its key interest rates in April unless energy and other commodity prices plunge between now and then, and such a drop appears extremely unlikely even if North African unrest doesn’t escalate. 

The likely timing of an interest rate hike was not the only announcement today with an element of surprise.  Changes in unconventional measures that seemed probable were not announced.  Fixed rate three-month refinancing operations were extended through the second quarter, with the rate to equal the average rate of one-week tenders over the life of the respective tenders.  Nor were any explicit announcements made of ways to wean addicted banks from their heavy reliance on emergency liquidity.  So while the main monetary policy, which uses interest rates and reserve requirements to secure medium-term price stability and to anchor expected inflation, was put on a higher level of alert leading presumably to actual tightening next month, the status quo was retained for unconventional policy measures that seek to improve market functionality and enable the main policy stance to achieve its desired effect.  In this way, officials underscored the separation principle between the two arms of policy.  They are decided on different criteria and do not need to be coordinated.

In the question and answer portion of the press conference, Trichet admonished that today’s message doesn’t guarantee a rate increase in April but admitted that such an action is “possible.”  He would not be drawn into discussing the possible size of such a move.  Only twice in its existence has the ECB raised its key rate by an increment other than 25 basis points, and those instances came very early in the bank’s existence, first in November 1999 and later in June 2000.  Both of those tightenings measured 50 basis points in magnitude, but never have officials needed to tighten from so low a nominal and inflation-adjusted level, respectively 1.0% and minus 1.4%, as they face now.  The question was a reasonable one to ask.

The euro spiked as high as $1.3977 following Trichet’s bombshell and is currently trading 0.6% higher on balance at $1.3935.  When questioned in the press conference if ECB officials were satisfied with the euro’s level and might welcome downward pressure on imported inflation resulting from the higher vigilance of the central bank, Trichet declined to comment.  The $1.4000 level represents a psychological barrier.  Had it not been looming so near, the euro’s rise today probably would have been greater.  Meanwhile, the yield on 10-year German bunds increased six basis points since earlier today and is ten basis points above yesterday’s close.

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

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