ECB Keeps a Wary Eye on Inflation
Both the European Central Bank and Bank of England left official interest rates unchanged at their respective Oct. 4 policy meetings. It seems both banks want to wait for more data to assess the impact of the recent market turbulence. But while the BoE now seems unlikely to hike rates again this year, the ECB has left all its options open, and has maintained a tightening bias.
The ECB's introductory statement at the press conference that followed the meeting was pretty much as we expected. ECB President Jean-Claude Trichet was adamant that the baseline scenario has not changed: Upside risks to price stability remain, and the ECB stands ready to act if need be. The strong euro does not seem to have had an impact on monetary policy yet.
However, while Trichet said the ECB "stands ready to counter upside risks to price stability," he also admitted that uncertainty has increased and that "it remains necessary to gather additional information and examine new data before drawing further conclusions for monetary policy."
Growth Elsewhere Offsets U.S. Slowdown
On the economic analysis, Trichet said, "On the basis of the available data, it appears that the sustained real economic growth" seen in the 2007 first half continued through the summer. The central bank noted that financial market turbulence has contributed to a dip in business and consumer confidence, but stressed that indicators "remain above their historical averages and continue to point to ongoing sustained growth during the second half of 2007."
Looking ahead, the ECB is still sticking to its main scenario of gross domestic product growth at around trend next year, which is based on the view that strong growth elsewhere will offset the slowdown in the U.S. economy. The bank believes that consumption growth will pick up in line with real disposable income, as "employment conditions remain supportive." The ECB admitted, however, that due to financial market turbulence, the uncertainty surrounding this outlook has increased.
As in the previous month, the ECB notes that the risks for growth are to the downside, relating mainly to the potential for "a broader impact from the ongoing reappraisal or risk in financial markets on confidence and financing conditions, concerns about protectionist pressures and possible disorderly developments owing to global imbalances, as well as further oil and commodity price rises." This assessment is little changed from the September statement.
Risks on the Upside
Turning to inflation, the ECB noted the sharp acceleration in the EU's harmonized index of consumer prices (HICP) inflation measure to a 2.1% year-over-year rate from just 1.7% in August. The central bank said, "We are now entering a period during which unfavorable effects from energy prices will have a strong impact on annual HICP inflation rates." It added that, due to the combination of a sharp fall in oil prices a year ago and a renewed rise now, inflation will remain "significantly above 2% in the remaining months of 2007 and in early 2008, before moderating again. Largely as a consequence of capacity constraints and relatively tight labor market conditions, inflation is expected to be around 2% on average in 2008."
This would already be in line with the ECB's upper limit for price stability, and the ECB still judges risks to the outlook to lie on the upside. They continue to include further increases in oil prices and agricultural products as well as increases in administered prices and "indirect taxes beyond those anticipated" so far as ongoing risks.
The ECB also warned, "Taking into account the existence of capacity constraints, the favorable momentum of real GDP growth observed over the past few quarters, and the positive signs from labor markets, stronger than currently expected wage developments may occur, and an increase in the pricing power in market segments with low competition could materialize." This last statement is, if anything, a tad more hawkish and direct than in September, especially as the ECB no longer said that these risks could also disappear.
Staying On Message
All in all, the statement is still pretty much in line with the central bank's September remarks, and in our view confirms the ECB's tightening bias. What has been notably absent is the phrase "monetary policy is accommodative," which could suggest that the upturn in market rates, coupled with tightening lending standards and a rising euro, has led to a tightening of monetary conditions. However, when quizzed about this in the press conference, Trichet was adamant that rates could still go up even if monetary policy is not accommodative.
Indeed, several of the questions in the press conference were intended to force Trichet to admit that the ECB is now in neutral due to the stronger euro and market turbulence, and that there could even be rate cuts. However, Trichet refused to comment on the exchange rate beyond the usual reference to the G7 statement that excess volatility is undesirable. And he stressed repeatedly that the ECB continues to see upside risks to price stability, and is ready to act in order to anchor inflation expectations.
Too Soon to Assess
The bottom line is that the ECB's tightening bias remains intact, and the ECB is willing and ready to act if its central scenario is confirmed. It is clear that much will depend on market developments. Trichet stressed once again that the ECB will do everything to help stabilize money markets. So far, turbulence has increased uncertainty, but not changed the ECB's base scenario, and we would need to see a further deterioration in confidence and repercussion on real economic growth before the ECB is ready to abandon its tightening bias. As of now, the risk is for another rate hike this year.
Turning to the BoE, the bank left its benchmark Bank Rate unchanged once again at its October meeting, and is still waiting for a clearer picture of the ramifications of mixed signals. There was no statement, shifting the focus to BoE minutes—slated for publication Oct. 17—for further insight on monetary policy. Members of the bank's Monetary Policy Committee have said that it is too soon to assess the impact of financial turmoil on the real economy. All in all, the BoE appears to be in wait-and-see mode, and we expect the BoE to remain on hold at least through yearend.