One ECB Rate Hike Down, One to Go?
The European Central Bank did the expected and hiked its benchmark refinancing rate by 25 basis points, to 3.75%, on Mar. 8. ECB President Jean-Claude Trichet said at a press conference that interest rates remain moderate and monetary policy accommodative. This suggests that further rate hikes are likely. Our central scenario at Action Economics calls for another 25-basis-point move in June. Meanwhile, the Bank of England left rates unchanged on Mar. 8, but inflation pressures also suggest that a rate hike is likely before midyear.
Beyond June, ECB rates could go even higher than 4%. Trichet was adamant that while he may have indicated that rates are getting closer to neutral—i.e., neither too accommodative nor too restrictive of growth—he didn't say rates are closer to the peak of the current tightening cycle. This could be interpreted as a sign that with economic growth in the euro zone (the countries that use the euro as their common currency) above potential, interest rates could rise above 4% in the second half, a level we would consider to be around neutral.
As for financial markets' recent gyrations, Trichet suggested that recent volatility was rapid but not abrupt and reflected a reappraisal of risks. This suggests that developments so far haven't changed the ECB's rate outlook.
Lower Oil Prices a Boon
The ECB noted that fourth-quarter gross domestic product growth was stronger than previously anticipated, up 0.9% over the previous quarter. The solid showing is seen as a sign of ongoing robust growth in the euro zone, with both domestic demand and exports making significant contributions to overall growth. According to the ECB, this confirms "the sustained and broad-based nature of the current expansion."
At the same time, surveys and estimates based on key economic indicators—including surveys of purchasing managers—support "the assessment that robust economic growth has continued into 2007," the ECB noted.
The ECB continues to stress that the medium-term outlook for economic activity remains favorable, and that the conditions remain in place for solid growth. Global economic growth is judged to be more balanced, and while the ECB acknowledges that it has moderated somewhat, it stressed that growth remains robust and supported by lower oil prices.
Higher Growth Seen
Domestic demand is also expected to "maintain a relatively strong momentum," helped by favorable financing conditions, "balance sheet restructuring, accumulated and ongoing strong corporate earnings, and gains in business efficiency." At the same time, consumption is expected to strengthen over time, in line with improvements in the labor market and in real disposable income.
The central bank's favorable assessment is reflected in upward revisions to the economic projections compiled by ECB staff that were released on Mar. 8. The new set of forecasts sees GDP growth of 2.1% to 2.9% this year, vs. the ECB's previous December forecast of 1.7% to 2.7%. GDP for 2008 is seen at 1.9% to 2.9%, vs. the 1.8% to 2.8% expected previously. The central projection of a 2.5% GDP increase this year would have growth exceeding its potential again. The ECB does see medium- to long-term downside risks to growth. But while this may speak against a restrictive monetary policy, growth in excess of potential this year and in 2008 leaves no need for ongoing monetary stimulus.
Turning to inflation, the ECB is playing down the importance of current low inflation rates. The new set of staff projections projects inflation at 1.5% to 2.1% this year, vs. 1.5% to 2.5% in the December forecasts. This would suggest a midpoint below 2%—in line with the bank's view of price stability. However, Trichet stressed once again the need to look beyond short-term developments, which have benefited from lower oil prices.
Inflation is seen at 1.4% to 2.6% next year, which is above the 1.3% to 2.5% expected in December and would bring the midpoint to 2%, in line with the upper limit for price stability.
More fundamentally, the ECB stressed again that wages pose "significant upside risks to price stability," and stressed that it's "crucial that the social partners continue to meet their responsibilities."
As for the BoE's decision, we at Action Economics suspect it was a tight vote, and that recent equity-market volatility tipped the balance in favor of a steady hand, as opposed to a rate hike. We expect to see another 25-basis-point rate hike from the BoE, bringing the policy rate to 5.50% before midyear. However, we don't expect a move in April unless the wage round starts to go badly. Instead, the Bank's Monetary Policy Committee will probably wait to see what the new May Inflation Report offers before considering any moves.