ECB Preview

July 5, 2011

Analysts are prepared for the ECB’s second interest rate hike of the cycle.  It will be announced at 11:45 GMT on Thursday followed by a press conference to start at 12:30 GMT.  Matters of most interest concern 1) the size of the increase, 2) the timing of the next increase that is implied in the ECB text and remarks during Q&A, 3) whether unconventional measures to support the financial markets will be tightened as well, and 4) the willingness of monetary officials to allow Greek sovereign debt to serve as acceptable collateral.

Moves of 25 basis points have become the prohibitive favorite size of ECB rate increases.  The last interest rate rise to exceed a quarter percentage point was made over eleven years ago in June 2000.  The last press conference on June 9 contained numerous clues that a tightening would be made this week, most notably the use of the V-word for vigilance.  Given the opportunity last Thursday to reinforce those signals or put some distance from them, President Trichet again used the V-word in EU parliamentary testimony.  On-year CPI inflation averaged 2.75% in March-June, 850 basis points above the target ceiling.  Labor costs increased 2.6% in the year to 1Q, accelerating from an on-year pace of 1.5% in the final quarter of 2010.  Although money and credit show low on-year rates of expansion, ECB officials in June made the point that their levels are sufficiently abundant to accommodate excessive inflation.   No indication has been given that the tightening might exceed 25 basis points for the refinancing rate and the deposit and marginal lending rates that flank it. 

Nor should there be any reason to intensify the degree of tightening.  One theme emphasized often is that the ECB is guided by Ezone data, not the trends of individual members.  A diversity of economic trends among member economies isn’t important and is the norm rather than the exception.  But ezone-wide data tell a tale of significantly slower economic momentum at the end of the second quarter.  The composite purchasing managers index (PMI) for both manufacturing and services in June was 53.3, down from quarterly averages of 55.6 in 2Q and 57.6 in 1Q.  Retail sales volume dropped 1.1% in May.  If unchanged in June, sales will have decline at a 2.2% annualized pace in the quarter.  The retail PMI printed in June at 48.8, that is below quarterly averages of 51.5 in 2Q and 53.1 in 1Q.  The economic sentiment index reading of 105.1 in June was down from quarterly averages of 105.6 in 2Q and 107.4 in 1Q.  Industrial orders only reversed half of March’s 1.5% decline in April.  The jobless rate in the euro area, as in the United States, has fallen at a snail’s pace.  Such was 9.9% in March-May after three consecutive 10.0% readings.  A year ago in May 2010, unemployment stood at 10.2%.  The ZEW expectations index, a gauge of investor attitudes toward Euroland, has weakened sharply from 31.0 in March to 19.7 in April, 13.6 in March and minus 5.9 in January.

The ECB statement of April 7 when rates were hiked the first time spoke of monitoring developments very closely.  Including the adverb “very” had created some initial speculation that the second tightening by the ECB might occur in June, just two months later and when new forecasts would be unveiled.  Statements released in prior cycles to accompany a rate increase had sometimes left the word “very” out.  It turned out that officials ultimately went with a three-month interval between the first and second rate hikes.  By inserting the word “very,” they left themselves with an option to move in June or July, and in all likelihood they really didn’t know in April which choice would be made.  Amid uncertainty, it was a nice verbal touch to create the two options with the inclusion of a single word, — so clever in fact that they are apt to consider the tactic again.  If “very” is in Thursday’s text, they might tighten a third time in September.

But October will be the more likely timing of a third rate hike whether or not a September possibility is established.  The regional economy is slowing, and commodity prices are well off their highs.  Equally important is the relentless pressure on the peripheral members of the euro area.  Between June 10 and July 4, the ten-year spreads of Ireland and Portugal’s debt versus German bunds widened by 47 and 57 basis points and each exceeded 800 basis points.  Greece’s differential narrowed by 65 bps but remained over 13.25 percentage points.  Italy’s spread was wider at the end of the period almost at 200 bps.  The June statement already established the point that unconventional support through longer-dated fixed refinancing tenders would not be tightened for another quarter.  Given the state of the sovereign debt crisis, no reason exists to call off those measures now.

Among the hardest questions that President Trichet will have to field will be ones dealing with whether Greek debt instruments will constitute acceptable collateral to the central bank, since S&P has now voiced its disapproval even of such a selective and voluntary default.  That view sets up the stage for a further downgrade of Greek debt by that credit rating agency to below investment grade.  The lead story of today’s Financial Times quotes “a senior finance official” as saying that the ECB will disallow Greek debt only if Fitch and Moody’s also make the same ruling as S&P.  Reporters will try to get an unqualified clarification on this key issue for Greece, European banks and world financial markets.  Trichet may not want to go there.  If the statement addresses this specific matter, he will probably just repeat over and over that he has nothing to add beyond what’s said in the statement.

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



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