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No October surprises from the European Central Bank: The ECB did just what markets had expected and hiked its benchmark interest rate, the so-called refinancing rate, by 25 basis points on Oct. 5, to 3.25%.
As expected, the press conference after the announcement confirmed that another rate hike before yearend is in the cards, but also that rates will likely remain on hold in November. We at Action Economics expect another 25 basis-point hike in December, bringing the yearend refinancing rate to 3.5%.
The ECB remains relatively optimistic on the growth outlook, at least for the coming quarters. ECB President Jean-Claude Trichet said available information supports the assessment that economic growth will remain robust, if possibly somewhat lower than in the second quarter. This indicates that the ECB is looking less at the sharp decline in the German ZEW sentiment survey than at the relatively robust sentiment found in recent Manufacturing PMI, and the latest European Union commission survey.
Looking ahead, Trichet stressed the familiar line that conditions remain in place for solid growth next year, even though he admitted that the German value-added tax (VAT) hike next year is likely to cause some volatility in short-term growth rates. At the same time, the ECB highlights that if the decline in energy prices is sustained, it will also have a positive impact on the economy.
PROTECTIONIST PRESSURES. Nevertheless, the risks to the growth in the long term are on the downside, due mainly to the possibility of a renewed increase of oil prices, fears of a rise in protectionist pressure, and the possible impact on markets of global trade imbalances.
The ECB's statement maintains that the risks to inflation lie on the upside. Headline inflation did fall below the ECB's upper limit for price stability of 2% in September, but Trichet stressed that this is likely to be a temporary phenomenon and that, on average, inflation is seen above 2% this year as well as next. Inflation risks still include a stronger pass-through of past oil price rises into consumer prices than currently anticipated, additional increases in administered prices and indirect taxes, and the risk of a renewed rise in oil prices.
Also the ECB has stepped up its language with regards to risk of stronger wage growth, and the statement now says that "stronger than currently expected wage developments pose substantial upward risks to price stability."
INFLATION RISK. Upside risks to inflation also stem from the monetary backdrop, with the ECB stressing that the rate of monetary as well as credit expansion remains rapid. The ECB highlights the "persistent upward trend in the underlying rate of monetary expansion" since 2004, and that liquidity remains ample by "all plausible measures." The statement stresses that money growth needs careful monitoring, especially against the background of strong property markets in many parts of the euro zone.
The ECB's statement summarizes that inflation rates are expected to remain elevated this year and next, with the risks lying "clearly to the upside." Money growth also points to upside risks, and Trichet said that the ECB's baseline assumptions confirmed that a further withdrawal of monetary accommodation will be warranted. This is a clear indication that the ECB is planning further rate hikes down the line.
However, the statement does not include the word "vigilance," and Trichet said just that the governing council will "continue to monitor closely all developments." This confirms our view that rates are likely to remain on hold at the November meeting, and that the ECB will deliver another 25 basis-point hike at the December meeting. This is also confirmed by Trichet's comments in the question-and-answer session, when he said that he did not want to say anything to change market expectations for another rate hike this year.
LIQUIDITY OVERHANG. This last expected hike would bring the yearend rate to 3.5%. Trichet was very cagey about the rate outlook for 2007, and just said that the ECB will do what it has to do. This suggests that the ECB at this stage wants to keep all its options open, and await further data before committing to further moves. In December there will be a new set of economic projections from ECB staff, and it will be clearer if the current slowdown in energy prices is viewed as temporary.
With the benchmark interest rate at 3.5% and inflation above 2%, real rates will still remain very low, and monetary policy will generally still be accommodative at the start of 2007. This, and the need to gradually reduce the liquidity overhang, would suggest the need for further rate hikes next year toward a neutral level, which is seen as roughly 4%.
However, there is considerable uncertainty about the global growth outlook, and about the impact of the German VAT hike on growth and inflation. It seems likely that the ECB will maintain a slightly longer pause than the current two-month gap before delivering another hike in the new year. The March, 2007, meeting will bring another set of forecasts, and more clarity about the growth and inflation outlook. This may be an appropriate time to discuss the need for the ECB's next hike after December.
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