S&P thinks the conflicting risks of higher inflation and lower growth will lead to at least one ECB rate cut in the second half of 2008
European economies are entering a period of heightened uncertainty: On the one hand, soaring prices for oil and other commodities have just begun to translate into higher headline inflation, and further consumer price index, or CPI, acceleration is expected in the coming six months. On the other hand, the new heights reached by the euro and the British pound sterling exchange rates against the U.S. dollar bring further evidence that Europe is going to be most affected by the U.S. slowdown and the rebalancing of the U.S. trade deficit, Asian currencies (aside from the yen) having hardly moved against the dollar in the meantime.
In addition, the dislocation in credit markets will be felt for quite some time. The most recent survey on lending practices in the Eurozone, published by the European Central Bank (ECB) in October, reveals an abrupt tightening in lending criteria, consistent with a marked deceleration in lending to corporations and households.
The conflicting risks of higher inflation and lower growth put Europe's central banks in a difficult position. In Standard & Poor's opinion, monetary policies will converge in 2008 and move toward a more accommodative stance. Consequently, we believe the ECB will cut interest rates at least once, in the second half of 2008. We also expect the U.S. dollar to stabilize during that period, after nearing $1.55 against the euro ($2.20 against the pound) in the second quarter of 2008.
Economic Data Point to a Slowdown
According to the most recent data from the European Statistical Office, Eurozone gross-domestic-product growth rebounded quite strongly in the third quarter, from 0.3% to 0.7%. This rebound reflected a pick-up in Italy, where GDP growth was 0.4% (vs. 0.1% in the previous quarter), and The Netherlands (1.8% vs. 0.2%). Spain also enjoyed another fairly strong quarter, with growth of 0.7%, although that rate was the lowest since 2004.
Looking ahead, however, the view is far from upbeat. Recent survey results suggest the outlook for growth in the Eurozone has deteriorated significantly in the past three months: Industrial production fell by 0.7% in September, largely reflecting declines in France, Italy, and Ireland. More worrying, the business expectations index from the Center for European Economic Research (ZEW) in Germany plummeted in November.
Breaking down the index by industry reveals confidence in the insurance and banking sectors stabilizing at very low levels, while confidence in the manufacturing, services, and construction sectors has declined compared with previous months. Overall economic growth in the Eurozone is decelerating gradually, and this could be aggravated by the decline in bank lending and an acceleration in inflation affecting real-income growth.
Inflation: How Big a Problem?
We believe core inflation (once energy and other volatile items such as food and tobacco are excluded) is contained in the Eurozone and Britain, so we are not predicting a new inflationary cycle. Wage growth remains broadly contained, even though it has risen somewhat in some countries—notably Germany—in reaction to tighter labor markets and extended pay moderation in recent years.
Furthermore, the slack across Eurozone labor markets (coupled with many companies' ability to threaten to move production to locations with cheaper labor) is still sufficient to limit workers' bargaining power over pay. The latest data show Eurozone wage growth was limited to 2.5% year-on-year in the second quarter of 2007.
But central banks, whose mission is to ensure price stability in the medium term, cannot take this rather optimistic view for granted when setting interest rates.
The Bank of England: Caution Is in Order
The Bank of England (BoE) faces a particularly difficult decision for two reasons. First, it has been accused of taking a too optimistic view on inflation trends, cutting rates by 25 basis points in the middle of 2005 and leaving them unchanged until August, 2006, even though inflation had already started to accelerate. The Bank also has been criticized for its apparent change of tack with regard to the credit markets during the summer. With its credibility under scrutiny, the BoE must act cautiously.
On the other hand, the current credit crunch and resulting turmoil in the financial markets pose a particular downside risk to the British economy because the financial-services sector has been a crucial driver of growth in recent years. And the longer the turmoil continues, the greater the effect on the rest of the economy. By restricting credit to individuals and businesses and driving up short-term market interest rates, the turmoil is effectively leading to a tightening of policy. Mortgage rates have risen, increasing the risk of a hard landing for the housing market suffer. Consumer spending, meanwhile, is under increasing pressure from higher interest rates, muted real-income growth, and higher debt levels.
Standard & Poor's expects GDP growth in Britain to decelerate from 2.8% in 2007 to 2% in 2008, which should lead the BoE to start easing monetary policy, although probably not before the beginning of 2008. We therefore expect the BoE to lop 50 basis points off its current leading rate of 5.75% by the middle of 2008.
The ECB: Looking at Precedents
The tightening in lending criteria by Eurozone banks can be read as a de facto tightening of monetary conditions, similar in effect to an ECB interest-rate increase. In that context, the ECB has three choices: 1) It can decide inflation risks remain predominant, and hike interest rates one more time. 2) It can keep rates on hold, on the basis that conditions are tight enough, and simply stick to hawkish rhetoric at its monthly press conferences. 3) It can reckon growth is now most at risk, and set the stage for rate cuts in 2008.
Looking at precedents in the admittedly still-short history of the Bank, two opposing arguments can be put forward. In the first instance, it is plausible to say the current situation is similar to the period from mid-2004 to mid-2005, when economic growth was beginning to fall and surging energy prices were pushing up the CPI (to a high of 2.6% in October, 2005). At that time, the ECB responded with tough anti-inflation speeches but kept its leading rate flat. In the second instance, we look back to 2001, when growth was still robust in the monetary union, but inflation had begun to accelerate, reaching a high of 3.1% in May, 2001. A month earlier, the central bank had cut interest rates by 25 basis points, to 4.5%, starting a long chronicle of cuts that would eventually reduce the ECB rate to a low of 2% in June, 2003.
Indications for the Future
Historic parallels should always be drawn with a good deal of caution. Nevertheless, the two preceding examples suggest recent inflation trends alone aren't enough to predict to the ECB's next move. In the past the Bank has cut rates aggressively despite rising inflation and strong growth, as it did in 2001. It also has left rates alone when inflation was surging but growth was slackening, as it was in 2004.
The explanation for such asymmetric moves must be found elsewhere. It appears the ECB's responses have also been influenced by the broader monetary context in the OECD area, and more specifically by the direction followed by U.S. interest rates. In 2001, U.S. rates were declining rapidly (to a low of 1% in June, 2003). In 2004-05, by contrast, U.S. rates were rising rapidly.
What can be drawn from these findings as an indication for the future? The U.S. Federal Reserve has started to ease in the third quarter of 2007, and given the magnitude of the slowdown in the U.S. economy, we believe a further cut of 50 basis points is likely before the middle of 2008. We are, in other words, in a global context of easing by the monetary policymakers. The euro exchange rate against the U.S. dollar has responded strongly to wider interest-rate differentials between the U.S. and the Eurozone, further tightening monetary conditions in the single currency union. As growth continues to slow and inflation rates retreat, as we expect, the ECB will be in a position to consider cutting interest rates at the end of the first quarter of 2008.
Open to Interpretation
The Bank undoubtedly will orchestrate that change in stance very carefully. It may even run into a semantics problem because the financial markets have been conditioned to listen for clues about upcoming rate moves in President Trichet's statements. To the markets, "strong vigilance," for example, indicates an interest-rate increase in the next month and "vigilance" indicates an increase in two months, whereas the absence of a reference to vigilance is believed to signal no rate change in either direction. As yet, no coded words have been established to signal rate cuts.
Overall, we do not foresee an interest-rate cut from the ECB before the middle of the year. But there are now strong reasons to believe the Bank may not follow the current consensus view that rates will stay on hold through 2008.