On Thursday, European Central Bank President Jean-Claude Trichet signalled at a press conference in Vienna that interest rates are on hold at least for the duration of the current period of adjustment in the credit markets.
Financial Times Frankfurt correspondent Ralph Atkins who was at the press conference in Vienna, says in today's FT, that financial markets have started talking about a fall in eurozone borrowing costs next year. But Holger Schmieding, economist at Bank of America, said: “It would probably take a dramatic, protracted and wholly unexpected downturn in the economic data to trigger any rate cut discussion in Frankfurt.”
Nevertheless, Austin Hughes of IIB Bank in Dublin was "reading between the lines" and concluding that the ECB is playing a game of bluff, which it may carry on until it is "forced to cut." Hughes concluded that if US economic data continue to point towards greater downside risks for global growth, "market expectations of an ECB rate cut in the early months of 2008 will increase markedly."
Simon Barry, Senior Economist at Ulster Bank says that ECB President Trichet's remarks at the press conference suggest that it is too early to be confident that the next move is down. He says that eurozone interest rates are likely to be kept on hold in coming months. But the press conference "is a reminder that the outlook for interest rates in the eurozone remains subject to some upside risk, and not just downside risk as some commentators are suggesting."
AIB Global Treasury Economic Research says that conflicting trends suggest that the ECB will keep interest rates unchanged over the balance of the year, especially with the Fed recently cutting rates and the euro on the ascent.
The outlook for interest rates in 2008 is quite uncertain. However, if the monetary easing by the Fed staves off a recession in the US and activity improves there over the course of next year, it could bring rate hikes back onto the agenda in the eurozone. We also expect to see a return to more normal trading conditions in financial markets in 2008, if not in Q4 2007. Indeed, there have been some signs of improvement recently. Such a scenario should see an improvement in the eurozone economic environment next year. With the ECB still worried about upside risks to inflation, it implies that a further rise in ECB rates cannot be ruled out. Overall, we cannot help feeling that it may be how the US economy evolves next year that could prove the critical factor for the course of eurozone interest rates in 2008.
Jean-Claude Trichet stressed on Thursday, the importance of credibility in respect of anchoring inflation expectations. Last month, at the golden jubilee celebration of the Bundesbank, Trichet said that "the clear objective of price stability and the independence from executive branches...were not the only necessary conditions for the success of the Bundesbank as an institution. The additional and decisive condition has been the credibility it gained with the German people and with global financial markets. Credibility is not something that can be installed by decree, it has to be earned." This should not be overlooked in forecasting outcomes. Bank of America's Holger Schmieding hit the nail on the head when he said that economic prospects would have to deteriorate significantly in coming months for rate cuts to be on the agenda in early 2008. Put simply, the prospects of Austin Hughes of IIB Bank selling more mortgages, would likely come at the cost of significant job losses and Ireland would not be immune from the impact of a US recession. Blather on how easily we overcame the 2001 recession should be discounted. It was a light slowdown that was easily ameliorated by a huge plunge in interest rates in the US and Europe - a panacea that would not be replicated next time given the current fallout from what is viewed as a period when money was too cheap. The Euribor 3-month Interest rate has risen more than 0.50% since early August and is already having a bigger impact than the rate increase of 0.25% that the ECB had planned for last month, would have had, in the absence of the credit crunch. So the more important issue is when the risk premium of 0.50% evaporates than when the ECB would cut its current refi rate of 4.00%
AIB Global Treasury Economic Research- - Rate Rise in 2008 Cannot be Ruled Out:
The overall impression from recent eurozone economic indicators is that growth may be losing momentum. Indeed, GDP growth had already slowed to 0.3% in Q2, although this was largely due to a fall in fixed investment and a rundown of inventories, both of which should have reversed in Q3 boosting GDP growth.
More recent indicators are showing signs of weakening activity, suggesting that GDP growth may lose steam again in Q4. The EC’s economic sentiment indicator retreated from its cyclical highs over the summer months, before registering a particularly sharp fall in September. Meanwhile, the composite PMI indicator for the manufacturing and services sectors, which was running at a high level, registered a sharp fall in September also, to record its lowest reading in two years. These trends are borne out by leading activity indicators in the main eurozone economies, such as the Ifo, INSEE and ISAE business surveys, as well as national consumer confidence surveys. Nonetheless, all these indicators are still at levels consistent with reasonable GDP growth.
Despite these signs of a softening in activity, the ECB believes that over the medium term, the risks to inflation are on the upside. It points to the marked uptrend in oil prices and possible additional increases in administrative charges, indirect taxes and food prices. More fundamentally, wage increases could be stronger than currently expected, given the continuing positive trends in the labour market. The jobless rate has fallen to 6.9% in the eurozone, with a particularly sharp fall in German unemployment.
ECB officials also believe that the continued strong growth rate of monetary and credit aggregates poses another upside risk to price stability. M3 money supply rose at a rate of 11.6% year-on-year in August. Meanwhile, the growth in private sector credit also remained uncomfortably high at 11.8% year-on-year, driven in particular by strong loan growth to the corporate sector.
These conflicting trends suggest that the ECB will keep interest rates unchanged over the balance of the year, especially with the Fed recently cutting rates and the euro on the ascent.
The outlook for interest rates in 2008 is quite uncertain. However, if the monetary easing by the Fed staves off a recession in the US and activity improves there over the course of next year, it could bring rate hikes back onto the agenda in the eurozone. We also expect to see a return to more normal trading conditions in financial markets in 2008, if not in Q4 2007. Indeed, there have been some signs of improvement recently. Such a scenario should see an improvement in the eurozone economic environment next year. With the ECB still worried about upside risks to inflation, it implies that a further rise in ECB rates cannot be ruled out. Overall, we cannot help feeling that it may be how the US economy evolves next year that could prove the critical factor for the course of eurozone interest rates in 2008.
Simon Barry, Senior Economist, Ulster Bank:
All 66 economists surveyed by Reuters in its latest poll expected the ECB to leave euro zone interest rates unchanged at Thursday's October meeting. And sure enough, the meeting produced the expected outcome, with rates left on hold at 4% - the level at which they have remained since the Governing Council's last move (a 0.25% hike) in June.
Given the overwhelming consensus regarding the rate outcome, the real interest was always going to lie in the post-meeting press conference for an update on the ECB's current thinking. By way of background, recall that the ECB's early-August update had signalled its intention to raise rates in September. In the event, it stepped back from the September hike in the face of uncertainty about the impact of financial market turmoil on the economic outlook. And indeed, recent developments (including a stronger euro, much higher-than-normal interest rates in the money markets, and some signs of weaker economic activity in response to market turbulence) have prompted some observers to declare that the ECB's tightening campaign is now over and that the next move in rates could be down.
But ECB President Trichet's remarks at the post-meeting press conference suggest that it is too early to be confident that the next move is down. There were four elements to the ECB's message to the markets on Thursday. Firstly, the ECB confirmed its baseline scenario for the euro zone economy. That is, that real GDP is likely to continue to grow at rates around potential (which we consider to be around 0.5% per quarter) in coming quarters and into 2008. Support for the outlook comes from robust employment growth, low unemployment, healthy corporate profitability and robust global economic growth. Interestingly, he played down the significance of the reported decline in some measures of business and consumer confidence in September, noting that they remain above their historical averages. Second, the ECB is aware of the fact that this base case is subject to large uncertainty as well as downside risk stemming from the possibility that financial market developments could have a broader impact on the economic outlook. Thirdly, and importantly, even after taking account of the downside risks to growth, the ECB remains concerned about upside inflation risks from a number of sources, including food and energy prices as well as the possibility of faster wage growth. Fourthly, using a new formulation of language, the ECB indicated that it "stands ready to counter upside risks to price stability".
Interestingly, the ECB did drop the reference to 'policy being on the accommodative side' suggesting that the hike in rates that was signalled a couple of months back is not now seen by the Governing Council as quite as necessary as previously thought. And it is very clear that Trichet and co. are certainly not flagging an imminent hike in rates (which would have been done through the use of the phrase 'strong vigilance'). Rather, they remain very much in wait-and-see mode. However, with inflation risks still deemed to lie to the upside (even in the face of downside risks to growth), the ECB effectively retains a tightening bias. Overall, then, euro zone interest rates are likely to be kept on hold in coming months. But Thursday's press conference is a reminder that the outlook for interest rates in the euro zone remains subject to some upside risk, and not just downside risk as some commentators are suggesting.
Austin Hughes, Chief Economist, IIB Bank: ECB Is Only Slowly Changing It’s Mind
While Thursday’s European Central Bank decision to leave interest rates unchanged was almost universally expected, markets wanted to hear whether the ECB had significantly altered it’s assessment of the economic outlook in a manner that might change the outlook for interest rate policy.
In a rather guarded press conference, Mr. Trichet attempted to give the ECB room and time to manoeuvre. However, he also sought to emphasize that the ECB has not (yet) fundamentally changed its view on prospects for the Euro area economy or, more importantly, on a possible need to raise rates further. The ECB wants to keep the threat of higher interest rates alive, even if (or possibly because) financial markets have decided that rates are unlikely to increase further and market thoughts are now turning to what might cause rates to fall.
There are quite a few reasons why the ECB continues to hold the threat of higher rates over the market. The most straightforward one is that the all-clear on inflation can’t be clearly signalled at this time. We think weakening activity and a stronger Euro will prompt an eventual easing in inflation. However, inflation looks set to remain awkwardly above the ECB’s target until early 2008 unless energy prices tumble. So, it is understandable that the ECB should adopt a cautious view. Critically, it also appears the ECB are not willing to adjust downwards their outlook for Eurozone economic growth (at least publicly). Earlier on Thursday, the European Commission acknowledged that financial turmoil could shave around a quarter percentage point off Euro area growth in 2008. With weaker US growth and a stronger Euro acting in the same harmful direction, the ECB is likely to have to revise it’s current expectation that 2008 will see ‘real GDP growing at around trend potential’. To be fair to the ECB, it is correct that in the present circumstances any ‘assessment is surrounded by increased uncertainty’. Furthermore, Mr. Trichet did acknowledge that growth risks continue to be to the downside.
There were several hints in the language of Thursday’s statement that at least some members of the Governing Council are moving towards a gloomier view of the world. The most notable shift was in the categorisation of ‘good economic fundamentals in the Euro area’. As recently as last month, these were ‘the strong fundamentals of the Euro area’. Similarly, consumer spending is no longer expected to ‘strengthen further over time’ but will merely ‘contribute to economic growth’. Presumably this owes something to a sharp downgrading of forecasts by the German retail association and a notable deterioration in recent German consumer confidence data, particularly in the ‘willingness to spend’ element which has now retreated below it’s long term average. While Mr. Trichet kept the threat of a rate hike alive by highlighting that the ECB ‘stands ready to counter upside risks to price stability’, in answer to a question he added ‘if and when it will be appropriate to counter these risks’. This phrase substantially dilutes the threat of further rate hikes.
The most significant omission on Thursday compared with previous press statements is the assessment that ‘our monetary stance is still on the accommodative side’. In one respect this is only stating the obvious. Liquidity pressures and the rise in the Euro on FX markets have effectively generated a substantial tightening in monetary policy in the past couple of months. Mr. Trichet hinted that some negative impact from the credit crunch would be seen when the ECB releases its October bank lending survey tomorrow. He noted that households and large enterprises had suffered tighter lending standards of late. In addition, the surge in the value of the Euro since the ECB’s September projections were prepared is the equivalent of an interest rate rise of almost 25 basis points. As a result of the restraint on the Euro area economy coming from a stronger exchange rate and stiffer lending standards, the weakening in consumer and business sentiment acknowledged by the ECB is likely to continue.
Mr. Trichet was at pains Thursday to point out that the omission of the word ‘accommodative’ from the statement did not imply policy rates are now appropriate. However, reading between the lines of Thursday’s press conference and taking into account emerging signs of slower growth, it is probably fair to say that the ECB is in the process of attempting an orderly and dignified retreat from its tightening stance. This means the threat of higher rates will prevail for some time. In this context, the US Federal Reserve was still signalling inflation worries at it’s August 7th policy meeting but it cut rates by a greater than expected 50 basis points on September 18th. The ECB will be reluctant and slow to signal the ‘all-clear’ on inflation. So the threat of higher rates may remain with us until just before the ECB is forced to cut. Indeed, one important reason the ECB will talk tough is to prevent expectations of rate cuts building too forcefully in financial markets.
We also think some on the ECB council still favour a further rate rise even if a majority view is slowly emerging that rates have peaked. It is quite a distance to travel from this point to one where rate cuts are contemplated by a substantial number on the ECB governing council. However, markets move quickly and, even if economies change at a somewhat slower pace, the emerging cooling of activity could well intensify in coming months. If US economic data continue to point towards greater downside risks for global growth, market expectations of an ECB rate cut in the early months of 2008 will increase markedly.
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