Europe Interest Rates: One Rise, One Hold

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Eurozone: Inflation Risks Remain

As regards the inflation outlook, the ECB's introductory statement notes the dip in headline inflation to 1.8% year-over-year in April, from 1.9% in March. Looking ahead, the central bank stresses that inflation over the coming months will be heavily affected by base effects from last year's energy price volatility. This should mean that inflation will dip slightly in the months to come, before rising again toward the end of the year "to hover at levels around 2%," that is, in line with the ECB's definition of price stability.

However, the statement stresses that the medium-term outlook "remains subject to upside risks," relating to "the increasing capacity utilization in the euro area economy, the possibility of further oil price rises, and additional increases in administered prices and indirect taxes beyond those announced and decided thus far."

The ECB also stressed that it is "monitoring wage negotiations in the euro area countries with particular attention," and repeated the familiar line that it is "crucial that the social partners meet their responsibilities so as to continue to avoid wage developments that would eventually lead to inflationary pressures and harm the purchasing power of all euro area citizens." It also called for differentiated wage agreements that take into account price competitiveness positions, high unemployment, and productivity developments.

Money Supply Growth Downplayed

The focus on wage developments is nothing new, but the comments now seem to be a clearer warning that the relatively high wage deal in the German metal sector should not be taken as a blueprint for deals in other sectors and countries. There is also more focus on capacity utilization levels, which are indeed very high, and seem to confirm that further rate hikes are needed in order to keep inflation at bay in the medium term.

Upside risks to inflation also stem from the monetary backdrop. M3 money supply growth accelerated to 10.9% in March. The statement stresses that short-term developments can be affected by special factors and are subject to some volatility, which seems to downplay the importance of the renewed jump. Nevertheless, the ECB still warns that "taking into account both short-term factors and the underlying trend of the continued vigorous expansion of money and credit, there are clear indications of upside risks to price stability at the medium to longer-term horizons." So while the ECB is putting the recent acceleration in M3 into context, it still sees inflation pressures from the monetary side.

The ECB's introductory statement summarizes that it is important to "look beyond any short-term volatility in inflation rates" and that monetary policy has to take a medium-term perspective. This clearly plays down the importance of current Harmonised Index of Consumer Prices (HICP) inflation below 2%. The central bank stresses that "risks to the medium-term outlook for price stability remain on the upside, relating in particular to stronger than currently expected wage developments in a context of ongoing robust growth in employment and economic activity."

June Rate Hike Widely Expected

The summary continues that "given the vigorous monetary and credit growth in an environment of already ample liquidity, a cross-check of the outcome of the economic analysis with that of the monetary analysis supports the assessment that upside risks to prices stability prevail over the medium to longer term." Accordingly, "the Governing Council will continue to be strongly vigilant in order to ensure that risks to price stability over the medium term do not materialize." Looking ahead, the council says it will be "acting in a firm and timely manner to ensure price stability in the medium term remains warranted."

All in all, the fact that the ECB continues to see upside risks to price stability despite current moderate headline inflation, and that it stresses "strong vigilance" is needed, paves the way for a rate hike in June. Such a move is widely expected, and likely to be accompanied by an upward revision to the ECB growth projections. The main question is what will happen in the second half.

In the question-and-answer session, ECB President Jean-Claude Trichet remained cagey on the rate outlook beyond June, and just said that the ECB will do whatever is necessary to keep inflation at bay. He did say, however, that there are signs that previous rate hikes affected mortgage markets and house price inflation. Judging by market reaction, some have taken this as a sign that the ECB may be done in June.

Exchange Rate Is No Barrier

However, we believe that the ECB is keeping all its options open for the second half, which supports our view that 4% is not necessarily the peak in rates. There was nothing in Trichet's comments that would suggest that the ECB sees rates close to neutral, or that the ECB is in any way ready to remove its tightening bias. Clearly, growth in the eurozone and internationally, as well as exchange rate movements, will be key. But the door is open for more moves later this year. Based also on a relatively optimistic scenario for U.S. growth, we see room for two more rate hikes in the second half, for a yearend rate of 4.5%.

This is, to a large extent, based on our analysis of capacity utilization, which is at levels that would suggest the need not only for a reduction of the monetary stimulus, but in fact a tightening of monetary conditions. In this respect, exchange rates are currently not a problem and while the euro/dollar exchange rate is at relatively high levels, growth is much stronger than the last time we saw similar levels. The fact that Trichet hardly mentioned the exchange rate also suggests that the euro at current levels will not prevent further tightening.

Gewaltig is director of European economics for Action Economics.