ECB May Hang Firm Even as Eurozone Slows
Eurozone GDP growth fell short of expectations in the second quarter, and the fallout from the U.S. subprime crises has led to continued turbulence in eurozone money markets. Yet comments from central bankers still seem to suggest that the turmoil is being seen through the prism of price readjustment and that the European Central Bank's central scenario has not fundamentally changed. An expected September rate hike to 4.25% is still in the cards.
Second-quarter GDP growth in the eurozone slowed to just 0.3% quarter-over-quarter, down from 0.7% quarter-over-quarter in the first quarter of the year. Our forecast was 0.5% quarter-over-quarter, which was in line with the median, so results were much weaker than originally anticipated.
No sector breakdown was provided with the preliminary numbers, but it seems likely that volatility in the German construction sector, French export weakness, and inventory fluctuations all played a role. It also appears that consumption has recovered somewhat from the stagnation at the start of the year, while recent car sales are pointing to a gradual improvement.
Strong Manufacturing Sector
The country breakdown showed a deceleration in growth in all Big Three eurozone countries, with Italian numbers falling back to just 0.1% quarter-over-quarter. Spanish growth is starting to slow as higher interest rates start to hit the construction sector, and Greece even reported a sharp contraction in second-quarter GDP.
Overall, second-quarter GDP growth was clearly disappointing, but in our view it has to be seen in conjunction with better-than-expected growth in the first quarter. Special factors boosted the numbers at the start of the year, and we are now seeing a correction. Confidence levels have come off their highs, but on the whole remain at very strong levels. The manufacturing PMI is still firmly above the 50 point no-change mark, which indicates ongoing solid expansion in the manufacturing sector.
High Consumer Confidence
Financing conditions have remained relatively favorable, and there is no sign so far of a tightening in bank lending standards, although it will become more expensive for companies to borrow on the corporate bond market. Unemployment has fallen to very low levels, and consumer confidence is quite high, which should support consumption. And so far there is no sign that the stronger euro is hampering export growth.
Overall, we are looking for a relatively quick rebound in growth, with growth rates of around 0.5% to 0.6% in the second half of this year and into 2008. This is broadly in line with the European Commission's forecast. Our forecast for annual growth of 2.6% this year still has asymmetric risk to the upside, and 2008 and 2009 growth of around 2.4% is also still feasible.
Risk factors include the housing market in countries such as Spain, especially considering the reliance of the Spanish economy on the construction sector. Internationally, there is also the risk of a greater-than-expected slowdown in growth due to fallout from the subprime crises. Market volatility over the past few weeks and the liquidity crunch on money markets have highlighted these risks.
Interbank Rates Down
Yet central banks, while unhappy with the abrupt correction of risk aversion, are to a certain extent welcoming the reassessment of risk. Comments suggest that the ECB agrees that the economy remains fundamentally healthy—and with capacity utilization at high levels and money markets stabilizing, there is no clear sign that the central bank has called off a September rate hike, despite the disappointing second-quarter GDP numbers.
The ECB reacted quickly to the emerging liquidity crisis on money markets by injecting nearly €100 billion ($135 billion) in short-term funds on Aug. 9. It followed this up with more quick tenders, while successively reducing the amount allocated, thus draining part of the funds in subsequent tenders. Wednesday was the first day since last week without a fine-tuning operation, and despite the fact that a quick tender of €7.7 billion ($10.4 billion) expired overnight, interbank rates have fallen below the 4% refi rate.
This was likely because the allocation in yesterday's main refinancing operation was very generous. The ECB allotted €310 billion ($418 billion), much more than the benchmark allotment of €236.5 billion, which was based on the ECB's own liquidity forecast. Despite this, the weighted average allotment rate was relatively high at 4.10%, which suggests that the ECB aimed to keep rates reasonably low with the generous allocation.
Pricing Risk Appropriately?
However, the ECB now has to drain the additional funds in coming weeks, and one could argue that its quick action to cover banks may create a "moral hazard problem," by failing to encourage them to increase their risk protection in the future. Why tighten standards if the ECB is there to bail you out?
In any case, both the ECB and Bundesbank in separate statements this week suggested that markets are stabilizing and that what we have been seeing is to a certain extent a normalization of risk assessments, which is quite welcome. There was no indication that the central bank has called off the September rate hike, which it hinted at after the last meeting.
Banks have warned for some time that markets are not pricing risk appropriately. While they may now regret the abrupt correction, events so far have not fundamentally undermined the arguments for further rate hikes. On the contrary, the hawks at the ECB have been warning that excess liquidity could cause price bubbles on asset markets, which in turn would imply the risk of sudden corrections and instability. Events over the past week will only strengthen these arguments, and a September rate hike is still in the cards.
Still, the next meeting is still more than two weeks away. It is clear that the ECB is watching developments carefully and will not hike at any cost. When asked on Aug. 17 whether there is still need for "strong vigilance," Bundesbank President Axel Weber said only that the ECB will do what is necessary to maintain price stability, which indicates that the bank will not push ahead with a rate hike if circumstances don't warrant it. If markets fail to stabilize, the central bank can still move to a wait-and-see stance.
Fed Matches ECB's Move
However, after ECB President Jean-Claude Trichet effectively announced a hike at the last meeting, the ECB will make it very clear to markets if and when it calls off a move. So far this has not happened. And the Fed's decision to lower the discount rate does in our view not have a direct impact on the ECB's monetary policy.
The Fed's move effectively matched the ECB's decision to pump additional liquidity into the markets to keep interbank lending rates low. The ECB has a similar tool in the emergency lending facility, which currently stands at 5.00%. If the ECB wanted to maintain market stability while at the same time bringing rates to a neutral level, it could hike the main refi rate and at the same time keep the emergency lending rate steady or even lower it. Such a move could help reassure markets that there will still be sufficient liquidity available and keep overnight interbank rates in a relatively tight range.
Further tightening moves will depend on international developments. If a serious credit crunch and slowdown in U.S. growth evolves, the eurozone will feel the effect. If we see merely lower growth, the central bank may feel that it has done enough by bringing rates to neutral. Our central scenario still remains for another rate hike in December, but the odds for that have shortened.