How Bold a Move from the ECB?

Recent European Central Bank (ECB) comments indicate not only that a June rate hike is a done deal, but that at least some council members are toying with the idea of a bold 50 basis point move. While the ECB has remained tight-lipped on the issue of the recent euro appreciation, central bankers are likely keeping a close eye on the exchange rate. The implicit monetary tightening from a stronger euro, and the fact that the euro advance seems to be driven at least partially by interest rate differentials, would speak against a 50 basis point hike.

The ECB's monthly report for May stresses that monetary conditions remain very relaxed, despite the total of 50 basis point rate hikes since December of last year. This speaks of the need for "strong vigilance" with regard to upside risks to price stability. And ECB President Jean Claude Trichet highlighted that the ECB will continue to act in a timely manner in order to prevent inflation pressures from materializing. The question is not if, but by how much, the central bank will lift official rates at the June meeting, especially after Trichet did not answer a direct question on the issue at last week's press conference.

Some of the hawkish council members, including Germany's Axel Weber, already indicated that in their view, small hikes may not be sufficient to bring rates to a level consistent with medium-term price stability. However, at the moment, the exchange rate is actually doing part of the central bank's job, with a rising euro providing monetary tightening in the eurozone. The euro/dollar is slowly but steadily making its way toward 1.30. This would be an appreciation of 10% from the end of December -- a significant rise in a relatively short time.


  So far, exporters have remained surprisingly quiet on the issue, probably because they are still benefiting from previous exchange rate declines, with euro/dollar still down 4.7% year-over-year in April. Furthermore, this is to some extent an issue of U.S. dollar weakness, rather than euro strength, with the real trade weighted index (TWI) up just 2% since the end of last year.

Nevertheless, exchange-rate developments are having an impact not only on the growth but also the inflation outlook. These developments will play a role in the ECB's monetary-policy analysis. The EU Commission's Monetary Conditions Indicator (MCI) gives some idea about the impact of a stronger exchange rate. The MCI is an aggregate measure of changes in short-term interest rates and the exchange rate, weighted by their relative impact on macroeconomic variables such as GDP or prices.

For this index, much depends on the weights attached to the variables and the so-called MCI ratio, which represents the depreciation of the exchange rate that is needed to offset a 100 basis point increase in short-term interest rates (or vice versa) on the macroeconomic variable concerned. The exchange rate will play a smaller role for a relatively closed economy than for an open economy.


  A wide range of different MCI ratios has been suggested for the eurozone. The EU commission's MCI, which is based on simulations in the OECD's interlink model, uses a ratio of 6:1 -- that is, a 6% appreciation of the euro is equivalent to a 100 basis point hike in official interest rates. This seems to be the consensus of most analysis.

With this measure, the 2% appreciation of the trade-weighted index would be equivalent to an interest-rate hike of more than 25 basis points. So the total effect on the economy from interest-rate hikes as well as exchange-rate movement is equivalent to a total of 75 basis points in rate hikes.

This could give the ECB some room to stick to a modest increase in official interest rates rather than shift to bold 50 basis point steps. There are two more arguments favoring a measured tightening cycle. One is that there are still downside risks to the medium term growth outlook. True, growth will approach trend this year, but it will also be boosted by special factors, such as consumers bringing forward major purchases ahead of next year's VAT hike in Germany.


  However, the latter will cut back growth in the largest eurozone economy to just 1.2% at best next year. The Bundesbank is calculating growth of just 1%. Considering that monetary policy decisions take six to 18 months to affect the economy, this means the ECB will have to be careful not to throttle still modest growth.

This is especially true as the eurozone is experiencing a typical export-led recovery, as Trichet pointed in the press conference last week. Strong export demand has kickstarted investment activity but hasn't yet led to a real improvement on the labor market and consumption. And as long as consumption remains stagnant at best, there are still downside risks to growth, especially if the economy is hit by a double whammy of higher interest rates and an appreciating currency. Bold interest rate hikes will only further boost the euro.

The concept that links interest-rate movements to exchange rates is covered interest parity. The return for a foreign investor with a eurozone investment is a function of both the interest rate and exchange-rate movement. The investor can cover the exchange rate risk by hedging.


  Covered interest rate parity states that the relationship between the forward and the spot rates of the euro/dollar corresponds to the interest-rate differential in the U.S. and the eurozone. If interest rates in the U.S. are higher than in the eurozone, the forward exchange rate must also be higher to ensure that the return on domestic investment and foreign investment hedged by a forward transaction are equal.

An article in the Bundesbank's monthly report for July, 2005, looks into the empirical evidence for covered interest parity, and shows that it holds for the euro/dollar. One way to exploit interest rate differentials is "carry" trades. This involves borrowing funds in the country with lower interest rates and investing them in a country with high interest rates.

These trades aren't hedged because -- via covered interest parity -- this would preclude arbitrage profit. If the exchange rate doesn't change, the yield on the carry trade is equal to the interest-rate differential. If the high-interest currency appreciates, the total profit will be boosted by the exchange-rate advantage.


  Recent euro/dollar movements and the appreciation of the euro after some of Fed President Bernanke's comments show that interest-rate differentials play a role in the recent euro advance. However, this means a 50 basis point move from the ECB would further push up euro/dollar, and thus lead to additional monetary tightening.

Not surprisingly then, EU commissioner Joaquín Almunia today called on officials to be "vigilant" about the exchange rate. He did not mention the ECB explicitly, but considering that the word "vigilance" is a key part of ECB-speak indicating higher rates, the reference is pretty clear.

Exchange-rate implications and the uncertainty about the medium term growth outlook should keep the ECB sticking to a moderate tightening pace in the current cycle. Our central scenario remains for a 25 basis point hike in June, even though a bold move certainly cannot be ruled out.