As expected, the Bank of England and the European Central Bank left their respective benchmark interest rates unchanged at their Mar. 6 policy meetings. The ECB's press conference after the announcement confirmed Action Economics' assessment that the central bank is not ready to consider rate cuts yet and remains focused on inflation risks, even though the bank's bias toward tightening rates has clearly disappeared, and the ECB now has a neutral policy stance. The news disappointed those in financial markets looking for quick cuts. ECB President Jean-Claude Trichet also remained reluctant to comment on the strength of the euro.
The ECB's introductory statement in the press conference proved less dovish than many had hoped, with no sign that the bank is in any mood to cut rates soon. Trichet said recent data confirmed that "there are upside risks to price stability over the medium term, in a context of very vigorous money and credit growth." The important first paragraph of the statement also repeated that economic fundamentals in the euro zone are solid and that data point to "moderating but ongoing" real growth. However, the ECB noted that "[u]ncertainty resulting from the turmoil in financial markets remains high."
Against this backdrop Trichet & Co. emphasize "that maintaining price stability in the medium term is the main objective in accordance with the ECB's mandate." Trichet also said that the ECB believes "the current monetary policy stance will contribute to achieving this objective" and that the ECB "remains strongly committed to preventing second-round effects and the materialization of upside risks to price stability over the medium term."
The ECB's monetary policy appears to mean that slowing growth does not necessarily equal rate cuts. At the same time, however, the fact that the ECB feels that current rates are appropriate to maintain price stability confirms that the ECB is in neutral gear and has shed the tightening bias, something Trichet was still reluctant to admit last month.
Cautious Projections for Growth
Trichet acknowledged the slowdown in euro zone gross domestic product growth in the 2007 fourth quarter. He also said that recent survey data "remain consistent with ongoing growth." Looking ahead, the ECB stressed once again that "the fundamentals of the euro area economy remain sound and the euro area economy does not suffer from major imbalance." The ECB admits that the global slowdown will have an impact, but still expects both domestic and foreign demand to support ongoing real GDP growth this year, albeit at lower rates than previously seen. Investment growth is expected to remain robust and consumption is expected to contribute to growth, in line with rising employment.
Economic projections prepared by ECB staff members show a 1.7% midpoint for growth this year, which is a clear downward revision from the previous midpoint of 2.0%. GDP forecasts for 2009 were cut to a midpoint of 1.8%, from 2.1%. Trichet stressed in the press conference that these are staff projections, which are based on a number of technical assumptions and do not necessarily reflect the view of the governing council.
Trichet repeated that "uncertainty about the prospects for economic growth remains unusually high" and that "downside risks to the outlook for economic activity continue to exist."
The warnings about the downside risks to growth and heightened uncertainty about the growth outlook are similar to the ECB's remarks last month.
As in the previous three months, Trichet said that risks relate "mainly to a potentially broader than currently expected impact of financial market developments." Other risks stem from the "scope for additional commodity price rises, protectionist pressures, and the possibility of disorderly developments due to global imbalances." The risks to the outlook are little changed from last month, although the staff projections confirmed the central bank's less optimistic estimate on growth.
Turning to inflation, the ECB acknowledged that February inflation remained at 3.2% under its harmonized index of consumer prices benchmark, which, according to the statement, "confirms the strong upward pressure on inflation in the short term, stemming mainly from the increases in energy and food prices in recent months." Trichet also said that the ECB expects "a more protracted period of relatively high rates of inflation" than it did a few months ago. Inflation is now expected to remain "significantly above 2% in the coming months" and to "moderate only gradually later in the year."
Trichet also warned that the "technical assumptions for short-term interest rates are taken from market expectations as at mid-February." The fact that Trichet felt the need to point that out confirms what one ECB member recently suggested, namely that markets are too optimistic on rates. Asked about this point in the press conference, Trichet said the ECB does not endorse current market sentiment and never does.
All in all, it was a relatively hawkish statement that confirmed the ECB's wait-and-see stance and made pretty clear that the central bank's sole focus is maintaining price stability. This means a downward revision to the growth outlook does not counterbalance upside inflation risks in their view, and hence will not prompt a rate cut. Trichet once again said that the decision was unanimous, with no calls for either cuts or hikes.
Keeping Options Open
However, the ECB now has officially confirmed that it is in a neutral stance, and that means it is leaving all its options open for the future. Uncertainty is indeed high, but if growth continues to slow there could be room for some modest monetary easing in the second half of the year. Yet, the market shouldn't expect swift and rapid action as we have seen from the Fed.
Turning to the BoE, the decision to leave rates on hold, after last month's cut, was widely expected. There was no statement, but recent commentary by officials suggests that there are a number of Monetary Policy Committee (MPC) members concerned about dislodging inflation expectations, with the British consumer price index seen heading to the 3% area in the near term.
All in all, the MPC is walking a fine line, noting the need to balance the risk of a sharp economic slowdown against "the risk that elevated inflation expectations keep inflation above target." As such, we would expect any further easing to be gradual, and conditioned on a further deterioration in growth prospects. We currently expect another 25-basis-point cut in May, bringing the benchmark Bank Rate to 5.00%.