As expected, the European Central Bank kept its benchmark interest rate, the refinance rate, unchanged at 1.00% on Oct. 8. Meanwhile the Bank of England kept its benchmark repurchase rate steady at 0.5% and left its asset purchase target steady at £175 billion.
The developments made it clear that European central banks are not planning to abandon their accommodative stance any time soon, and Action Economics continues to see steady policy until the end of this year and into 2010.
With growth stabilizing, though, we would expect both central banks to hike rates next year and the ECB could kick off the easing cycle with a March rate rise.
ECB Statement Confirms Policy Direction
ECB President Jean-Claude Trichet repeated in his prepared statement that "current rates remain appropriate" and that "the information and analyses" since the last meeting have confirmed the ECB's previous assessment. The bank noted the still slightly negative inflation rate in September, but added that its inflation benchmark, the harmonized index of consumer prices (HICP), is "expected to turn positive again in the coming months and to remain at moderately positive rates over the policy-relevant horizon."
The ECB sees inflation expectations "firmly anchored" in line with its aim of "keeping inflation rates below but close to 2%," and the important first paragraph of the statement also says that the monetary analysis confirms the "assessment of low inflationary pressure over the medium term," so that "price stability should be maintained over the medium term."
This introductory statement was clearly more optimistic on the growth outlook than the August statement and the comments confirm that rates have troughed. However, by stressing that uncertainty remains high and rates are appropriate, the ECB confirms it is not preparing for a quick rate hike.
On economic developments, the ECB noted that available survey indicators "signal an ongoing stabilization of economic activity." The ECB argues that in the near term the economy should continue to benefit from a "recovery in exports, the significant macroeconomic stimulus under way and the measures taken so far to restore the functioning of the financial system." On top of this, the inventory cycle is expected to contribute positively. Nothing new there.
However, the ECB also stresses that "uncertainty remains high" and that "the volatility in incoming data warrants a cautious interpretation of the available information." The statement goes on to say that the recovery "is expected to remain rather uneven" and while supported in the short term by a number of temporary factors, it will be affected over the medium term "by the process of ongoing balance sheet correction in the financial and the nonfinancial sector of the economy, both inside and outside of the euro area."
This paragraph was clearly designed to keep growth optimism in check and to explain why a stabilizing economy does not warrant higher rates at the moment. As with the ECB's August statement, the risks to the growth forecast are judged to be balanced. Downside risks are related to "a stronger or more protracted negative feedback loop between the real economy and the financial sector, renewed increases in oil and other commodity prices, the intensification of protectionist pressures, and the possibility of a disorderly correction of global imbalances."
Upside risks include "stronger than anticipated effects stemming from the extensive macroeconomic stimulus" as well as other measures, a quicker-than-expected rebound in confidence and less negative development on labor markets, and stronger-than-expected foreign demand.
Inflation Rates Seen as Stable
Trichet noted the slight decline in the year-over-year headline inflation rate to 0.3% in September from 0.2% in August. The introductory statement said that current negative rates are in line with expectations and reflect mainly base effects relating to the movement in commodity prices last year. These base effects should push the headline rate into positive territory within the coming months.
Looking further ahead, the ECB expects inflation to remain in positive territory "with overall price and cost developments staying subdued reflecting ongoing sluggish demand in the euro area and elsewhere." Trichet stressed once again that "inflation expectations over the medium to longer term remain firmly anchored in line with the Governing Council's aim of keeping inflation rates below, but close to 2% over the medium term." This suggests that the ECB does not see a real risk of widespread deflation, despite current negative inflation rates, but also that it does not see the risk of a sharp reversal in inflation rates.
Risks to the inflation outlook are judged to be broadly balanced. They relate not surprisingly to the general outlook for economic activity and higher-than-expected commodity prices. Trichet also repeated that "increases in indirect taxation and administered prices may be stronger than currently expected owing to the need for fiscal consolidation in coming years."
Credit Remains Sluggish
The central bank continues to acknowledge the subdued overall flow of bank loans to the private sector. Latest data suggest that growth of loans to households has been leveling off at low rates, while loans to nonfinancial corporations picked up slightly, after a few months of negative flows.
The ECB continues to argue that demand for credit has been dampened by the contraction in growth and that is likely to continue to depress loan growth to nonfinancial corporations. However, Trichet also said that "the ongoing improvement in financing conditions should support the demand for credit in the period ahead." There are no signs as yet that the ECB is seeing a serious risk of a full-blown credit crunch in the euro zone and it seems the central bank still attributes the slowdown in loan growth to subdued demand, rather than supply constraints.
Overall, the comments confirm that the ECB is now expecting a gradual recovery and that the interest rate cycle is turning. Inflation pressures are expected to remain subdued and the fact that the ECB stresses the remaining uncertainty regarding the growth outlook support a steady hand policy with rates expected to remain unchanged until the end of the year and into 2010.
BofE Stays on Course
The Bank of England left the repo rate steady at 0.5% at its October meeting and also kept its asset purchase target unchanged at £175 billion, as expected. The BofE reiterated that it expects the asset target to be reached in November and that the scale of the program will be kept under review.
The BofE's August inflation report predicted a year-over-year CPI rate of around 1.4% in two years' time, based on market rate expectations and the bank's asset purchase plan. Only by holding the repo rate stable at 0.5% throughout the forecast period, combined with reaching the £175 billion asset purchase target, is headline CPI expected to be in line with the 2% target in two years' time. This clearly shows that the central bank believes that significant stimulus is needed to boost the economy in order to ensure that inflation reaches target in the medium term.
Members of the bank's Monetary Policy Committee have also reiterated that the repo rate is likely to be raised before the BofE starts to unwind its asset purchase facility. We expect the repo rate to be raised in the third quarter of next year, which is earlier than the August inflation report suggests, as we still see inflation risk to be more of a threat in the longer term than any lingering risk of deflation.