As expected, the European Central Bank hiked rates and signaled that tightening will continue in coming quarters
The European Central Bank did the expected June 6 and hiked official interest rates by 25 basis points, with the key refinancing rate now at 4%. The press conference that followed the move was moderately hawkish, leaving the door open for further moves down the line, but not so much as to suggest a hike at the next meeting.
We at Action Economics continue to expect the next hike in September, with a previously forecast 25-basis-point hike to follow in December, which would bring the yearend rate to 4.5%.
Further Rate Hikes Likely
ECB President Jean-Claude Trichet said in the press conference that the hike was delivered in "view of the prevailing upside risks to price stability over the medium term" and that the decision will "contribute to ensuring that medium- to longer-term inflation expectations in the euro zone remain solidly anchored." The introductory statement said monetary policy is "still on the accommodative" side, rather than "is accommodative," which together with the absence of the phrase "rates are moderate" suggests that the ECB sees interest rates approaching the neutral level.
Nevertheless, the fact that the ECB still expects financing conditions to remain favorable and monetary policy to be accommodative would suggest that the tightening bias remains. That's especially true as the statement continues to stress that money and credit growth remain vigorous and that liquidity is ample.
The phrase "looking ahead, acting in a firm and timely manner to ensure price stability in the medium term is warranted" also suggests that further rate hikes are only a matter of time, as does the fact that the governing council will closely monitor all developments "to ensure that risks to price stability over the medium term do not materialize."
Favorable Growth Outlook
Turning to the economic analysis, the ECB said new information showed that the euro zone economy continues to expand "at a pace which is significantly stronger than generally expected a year ago." It points out that the 0.6% quarter-over-quarter growth rate in the first quarter was slightly stronger than anticipated and said that other available information, most notably survey data, suggests that "solid growth has continued into the second quarter."
The ECB is sticking to the line that the medium-term outlook for economic growth "continued to be favorable", and that the conditions are in place for sustained growth in the euro zone. As it stated in May, the ECB expects external conditions to provide support, while domestic demand is expected to maintain what is now judged to be "relatively strong" momentum.
The slightly more optimistic assessment of current growth trends is reflected in the new set of ECB staff macroeconomic projections, which have lifted the midpoint growth forecast for this year to 2.6% from 2.5%. The midpoint for 2008 has been revised down to 2.3% from 2.4%. The risk assessment surrounding the forecasts has not changed and is still judged to be broadly balanced over the shorter term, and to the downside over a medium to longer horizon.
Political Risks, Inflation
As in the previous statement, risks are related to "fears of a rise in protectionist pressures, the possibility of further increases in oil prices, concerns about possible disorderly developments owing to global imbalances," but also to "potential shifts in financial market sentiment." This last point is new and seems to reflect concerns about an underpricing of risks in financial markets, which central bankers have been warning against for some time.
Turning to the inflation outlook, the ECB notes the renewed rise in oil prices in recent months, and says that while inflation remained stable at 1.9% in May, this was "somewhat higher than expected a few months ago."The central bank continues to stress that the short-term profile of annual inflation will be heavily impacted by last year's energy prices and the resulting base effects. Inflation is therefore expected to fall slightly in the months ahead "before rising again significantly towards the end of the year." The May statement, that inflation is likely to be around 2% at yearend, has disappeared.
On this basis, the new inflation projections now assume a midpoint inflation rate of 2% this year, compared to around 1.8% in the March set of forecasts. The projection for 2008 has been left unchanged at 1.4% to 2.6%, whose midpoint of 2% is in line with the ECB's upper limit for price stability.
As in May, despite this latest rate hike the risks to the medium-term outlook are still judged to be on the upside. The risks are seen mainly on the domestic front, in particular rising capacity utilization and improving labor markets, which pose the risk of stronger-than-expected wage developments. The ECB also warns that in this environment "the pricing power in market segments with low competition may increase." The ECB continues to call for responsible wage policies, which take into account "price competitiveness positions, the still high level of unemployment in many economies and sector-specific productivity developments."
Holding the Line on Inflation
In the summary of the press conference the ECB once again stresses the need "to look beyond any short-term volatility in inflation rates" and repeats that the risks to the medium-term outlook for inflation remain on the upside. Vigorous money and credit growth in an "environment of already ample liquidity" confirm upside inflation risks.
The summary continues, saying that "given the vigorous monetary and credit growth in an environment of already ample liquidity, a cross-check of the outcome of the economic analysis with that of the monetary analysis supports the assessment that upside risks to prices stability prevail over the medium to longer term.…Accordingly, the Governing Council will monitor closely all developments in order to ensure that risks to price stability over the medium term do not materialize." "Looking ahead, acting in a firm and timely manner to ensure price stability in the medium term remains warranted."
All in all, the press conference held no surprises. We continue to expect the next rate hike in September, and this would mean the ECB will wait until August before reintroducing the phrase "vigilance," which signals a rate hike. Until then the ECB is likely to stick to the familiar line that it will do everything necessary to keep inflation under control.