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The European Central Bank (ECB) did the expected and left official interest rates unchanged on July 6. However, ECB President Jean-Claude Trichet stressed that the bank will exercise "strong vigilance" with regard to upside risks to price stability, which effectively paves the way for a rate hike in August.
The ECB also decided that the governing council's Aug. 3 meeting will not be held via teleconference but face to face, and that there will be a previously unscheduled press conference that day. Given these signs, a move seems almost certain. Trichet once again stressed that the ECB is not precommitted to the pace or magnitude of further hikes, but also indicated that there was no majority on the council in favor of an increase in the magnitude of rate hikes, which would point to a modest 25-basis-point tightening.
The introductory statement stressed that data since the last meeting confirm that the June rate hike was warranted. It also pointed out that interest rates remain at low levels and monetary policy accommodative, and that if the central bank's baseline scenario is confirmed, a progressive withdrawal of monetary accommodation remains warranted.
Those comments effectively confirmed that further rate hikes are only a matter of time. But true to the ECB's strategy of effectively announcing rate moves in advance, ECB head Trichet went further than that and said the ECB will exercise "strong vigilance" with regard to upside risks to price stability. This effectively means a rate hike is imminent.
OIL-PRICE WORRIES. The ECB is optimistic about the growth outlook, noting not only that growth regained momentum and became more broadly based in the first half of 2006, but also stressing that the conditions remain in place for continued growth. At the same time, inflation is expected to run above the ECB's upper limit for price stability of 2% both this year and next, with risks to the outlook remaining on the upside.
Contributing factors and risks include further oil-price increases, a stronger pass-through of previous energy-price increases, additional increases in administered prices and indirect taxes, and, of course, stronger wage dynamics than currently anticipated.
Trichet noted the acceleration in annual M3 money-supply growth to the highest level since the start of the European Monetary Union, and the central bank stressed that strong monetary dynamics and credit growth point to upside risks to price stability over the medium- to long-term horizon—especially in connection with strong housing price growth. It's no surprise, then, that the ECB feels that it needs to exercise "strong vigilance."
SMALL OR BIG STEP? Our central scenario had been for the ECB to wait until its end-of-August meeting before delivering another 25-basis-point hike. This would effectively have maintained the three-month rhythm exercised by the ECB so far. Also, the Aug. 3 meeting was initially intended to be held via teleconference, with no press conference. This would have made the second August meeting the more likely date for the next move.
The question remaining is one of magnitude. With a rate hike at the beginning of August, the ECB would effectively step up the pace of the tightening cycle from a three-month gap to a two-month gap. But the central bank won't likely step up the magnitude of moves as well. Indeed, ECB head Trichet indicated that a majority of council members wanted to stick with the tightening strategy followed so far. This would suggest that 50-basis-point hikes are not on the agenda at the moment. However, central bankers are eager to leave all options open, and economic data over the next month will be key.
Looking beyond the next move, there is now a non-negligible risk that the yearend rate will be higher than the 3.25% we anticipated previously, and a 3.5% rate seems more likely. However, while robust growth data may even support arguments for a further acceleration of rate hikes, it is worth keeping in mind that domestic demand this year will be boosted by special factors, mainly the World Cup and consumers bringing forward major purchases ahead of next year's German value-added-tax (VAT) hike. This would suggest a correction to growth next year. Indeed, it is difficult to say how German consumers will cope with the three-basis-point VAT rise, especially as health-care contributions will also go up. This should prevent the ECB from tightening rates too aggressively.