Today’s hawkish statement from the ECB means that a rise in interest rates from 1 per cent to 1.25 per cent is highly likely to be announced next month. Only a major discontinuity in Europe’s financial markets can now prevent it. The key question is whether this rate increase is just an isolated event, which proves to be mistaken and is therefore rapidly reversed – like the infamous quarter point rise announced by the ECB in July 2008, when the world economy was already in recession. Or does the ECB announcement definitively mark the low point for global policy rates? If so, it will prove to be the first step of the central banks’ “exit” process, and the start of a lengthy period of monetary policy normalisation.
President Trichet was a good deal more hawkish in his pronouncements today than was expected by most ECB watchers. They had expected a clear shift in that direction, but they generally believed that the governing council would stop well short of threatening an imminent rise in interest rates. Instead, Mr Trichet went as near as any central banker ever can to pre-announcing a rate hike for next month.
Mr Trichet tried to soften the message a little by saying that the likely rate rise would be only 0.25 per cent, rather than 0.50 per cent, and that it would not necessarily prove to be the start of a programme of continuous tightening. But he said the same thing when raising rates for the first time in the last cycle, in December 2005. This was followed by a series of quarter point increases in the policy rate at 3 month intervals during the following year. When the central banks start to shift their juggernauts, this often signals a gradual but lengthy process of change in the same broad direction. With European rates starting from levels which are well below “normal”, this seems to be the likely outcome over the next year or two.
What motivated the ECB to make this change a lot earlier than most people expected? The statement identifies the usual suspects – strengthening growth and rising inflation. GDP growth was revised upwards for 2011 from a median ECB projection of 1.4 per cent to 1.7 per cent, while inflation was revised up from 1.8 per cent to 2.3 per cent. In both cases, these ECB forecasts, which were made a few weeks ago, now look a little low. Business survey data published in the eurozone in 2011 Q1 point to GDP growth running at around 3 per cent, and spreading to the peripheries as well as the core. And the oil price shock will probably take the annual inflation rate above 2.7 per cent before too long.
To many observers, this still leaves the case for higher interest rates looking fairly threadbare, especially since monetary growth (the so-called “second pillar” in the ECB’s methodology) remains very sluggish. However, in a significant new paragraph, the ECB statement said:
The low level of money and credit growth has thus far led to only a partial unwinding of the large amounts of monetary liquidity accumulated in the economy prior to the period of financial tensions. This liquidity may facilitate the accommodation of price pressures currently emerging in commodity markets as a result of strong economic growth and ample liquidity at the global level.
In other words, the ECB is not willing to take the risk that the recent rises in commodity prices could feed into inflation expectations and wage settlements in the eurozone. And here we have the key difference between the ECB approach and that taken by the Fed. While Bill Dudley and Ben Bernanke have recently echoed the ECB in saying that they would act on interest rates if higher commodity prices began to feed through to inflation expectations and core inflation, neither of them seems willing actually to raise rates in advance of this happening.
With inflation in the US running at least half a point lower than it is in the eurozone, Mr Bernanke may feel that he has the luxury of waiting a little longer than the ECB to see what happens to commodity prices. After all, his central case is that the impact on inflation will be “at most, temporary and relatively modest”.
Furthermore, the state of the US labour market also means that he is still basically more disposed to be a dove than Mr Trichet. Although the employment numbers due to be published on Friday may show an encouraging monthly gain, the unemployment rate remains well above the structural rate in the US. In Europe, and especially in Germany, that is not so clearly the case. This explains a major part of the large and unusual difference in view on monetary policy between the two countries.
In the context of their own economies, they both might be right. But the contrast between the tightening which is now underway in both Europe and China, compared with the Fed’s accommodative stance, could have some fairly stark implications for the value of the dollar.
Finally, back inside Europe, the ECB decision could lob a hand grenade into the inter-government talks on sovereign debt, which lately seem to have become stalled. The central bank has made it clear that it wants national governments in future to accept the burden of buying troubled debt, and even of providing liquidity support for ailing financial institutions. So far, governments seem to have refused to help the ECB on this. Although the rise in interest rates does not necessarily mean that the ECB’s emergency liquidity support will be reined in, it is a clear threat to politicians that it soon might be.
Like the American navy, the ECB has today announced to wage negotiators and to European governments: “Don’t tread on me!”
Related reading:
ECB code words spell April rate rise – Money Supply, FT
Trichet calls for a ‘quantum leap’ amid ’strong vigilance’ – FT Alphaville
It’s Pretty Simple: The ECB’s Now In Hiking Mode – Business Insider
