ECB Nudges Interest Rates Upward
That the European Central Bank would hike interest rates at its June 8 council meeting was never in doubt. The only suspense for financial markets: how big of a move -- 25 or 50 basis points? The ECB opted for a 25 basis-point tightening, bringing the key refinancing rate to 2.75%. This was in line with economists' expectations, but markets had been pricing in anticipation of a more than even chance of a bold 50 basis-point move.
The ECB's move came on a day when financial markets gyrated in response to tightening liquidity around the globe. While the ECB's move was not unexpected, and the Bank of England left its policy rate unchanged, traders were caught flat-footed by a surprise 25 basis-point hike from the Bank of Korea, a larger than expected 175-point tightening in Turkey (the first move in five years), and a quarter-point hike in India.
For the ECB, there was no mention of the word "vigilance" in the introductory statement, which supports our view at Action Economics that rates will remain on hold in July. However, ECB President Jean-Claude Trichet also indicated that if growth develops along expected lines the ECB will continue to withdraw monetary accommodation -- that is, hike rates further. Judging by his comments, a 50 basis-point hike further down the line is still a possibility.
The ECB's introductory statement for the meeting stressed that the June 8 move was a decision that reflects the increased risks to price stability, and that interest rates remain accommodating even after the move. Growth is seen broadly in line with expectations, and the statement said the risks are judged to be balanced.
New ECB staff projections predict euro-zone gross domestic product growth of 1.8% to 2.5% this year, falling to 1.3% to 2.3% in 2007. This reflects a slight upward revision to the 2006 forecast and a slight downward revision to the 2007 forecast. Indeed, the midpoint for next year's forecast of 1.8% looks slightly below estimates for potential growth in the euro zone, which are for around 2% to 2.5%.
Growth below potential also means reduced risks for second-round inflation effects and the medium-term inflation outlook. Nevertheless, the ECB stresses that the risks to price stability remain on the upside and include further increases to oil prices, stronger pass-through effects from previous oil price increases than currently anticipated, stronger wage increases, and further increases in administered prices and indirect taxes.
NO MOOD CHANGE.
The ECB presented no real surprises during the news conference after the rate-hike announcement. Trichet said the ECB discussed the possibility of a 50 basis-point hike, but he stressed that there was an overwhelming consensus that a 25 basis-point move was appropriate.
When asked if the market is correct in expecting the ECB to hike rates by 25 basis points each quarter, Trichet said that the central bank is in the same mood as before, and that if its assumptions are confirmed, ongoing withdrawal of monetary accommodation is warranted. This only confirms that further rate hikes are likely down the line, but does not necessarily give any more indication about the timing or magnitude of further moves.
The exchange rate was one of the factors the ECB looked at, according to Trichet, though he was eager to point out that the central bank is not reacting to just one piece of data. This does not rule out, however, that the strength of the euro vs. the dollar was one of the reasons the ECB did not move by 50 basis points.
In trading, after the announcement was made, the euro fell against the greenback, sinking to fresh one-week lows, as the quarter-point hike disappointed the minority view that expected a bolder 50 basis-point move.
We currently expect the ECB to next hike rates at the Aug. 31 meeting by 25 basis points, bringing the key refinancing rate to 3%. Our central scenario is currently for a yearend rate of 3.25%. However, much will depend on future growth, as well as oil price and exchange rates. We currently believe that the most likely scenario is that the central bank will stick to its course of gradual rate normalization.
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