European Central Bank Lifts Key Interest Rate from 2.75% to 3.00%

ECB Delivers Heavily Signalled Interest-Rate Hike

The European Central Bank (ECB) raised its key interest rate by 25 basis points from 2.75% to 3.00% at its regular policy meeting on 3 August. This marked the ECB's fourth 25-basis-point interest-rate hike in the current tightening cycle, thereby bringing the cumulative increase to 100 basis points since December 2005. Prior to December 2005, the ECB had kept the interest rate at 2.00% for 29 months.

August's 25-basis-point interest-rate hike by the ECB represents an acceleration in the pace of monetary policy tightening, as it comes only two months after the previous increase in June. Following its initial 25-basis-point hike (from 2.00% to 2.25%) in December 2005, the ECB had previously acted at three-month intervals by raising interest rates by 25 basis points in both March (from 2.25% to 2.50%) and June (from 2.50% to 2.75%). As had been the case in each of its previous three interest-rate hikes in this cycle, the ECB had clearly signalled in advance of its August move that it was about to tighten monetary policy.

Specifically, when leaving interest rates unchanged at its July policy meeting, ECB President Jean-Claude Trichet noted that the bank needed to exercise "strong vigilance" to ensure that risks to price stability do not materialise, thereby using the "buzz term" that the ECB has regularly employed in this tightening cycle to signal an interest-rate hike at its next meeting. In addition, Trichet indicated that the ECB would meet physically on 3 August, rather than conduct the meeting by teleconference as it normally does in August.

The ECB is continuing to tighten monetary policy because of its ongoing concern that persistently high oil prices, as well as excessively strong money-supply and credit growth, will cause consumer price inflation to remain above its targeted rate of "close to, but just below 2.0%" over the medium-to-longer term. Furthermore, Eurozone economic activity is maintaining the marked overall improvement seen since mid-2005, indicating to the ECB that it can afford to become markedly less accommodative in its monetary policy stance.

In its statement accompanying the decision to raise interest rates by a further 25 basis points in August, the ECB observed that, "if our assumptions and baseline scenario are confirmed, a progressive withdrawal of monetary accommodation will be warranted". The ECB noted that annual Eurozone consumer price inflation had risen to 2.5% in May and then stayed at that level through until July. This is clearly above the ECB's medium-term inflation target of "close to, but just below 2.0%". Furthermore, the central bank concluded that inflation is likely to stay above 2.0% "during the second half of 2006 and on average in 2007". While the ECB expects wage moderation to continue in 2007, it believes that there will be upward influences on inflation from the indirect effects of past oil-price increases and from changes in administered prices and indirect taxes. The ECB concluded that "risks to the outlook for price developments remain on the upside".

In addition, the ECB again stressed concern about the strength of money-supply growth and loans to the private sector across the Eurozone, notwithstanding some moderation in June. The ECB argued that, "The dynamic of money and credit, in an environment of already ample liquidity, points to increased upside risks to price stability at medium to longer horizons."

Meanwhile, the ECB was upbeat about the Eurozone's current growth performance and prospects. It observed that growth continued at a sustained pace in the second quarter, having regained momentum in the first quarter. Furthermore, it noted that Eurozone growth had become more broadly based, with domestic demand improving. The central bank considered that, looking ahead, the conditions remain in place for continued economic growth at rates around potential. The ECB argued that continuing healthy global growth should support exports, while investment should benefit from favourable financing conditions, restructured corporate balance sheets, and healthy corporate earnings. Furthermore, it expects consumer spending to continue to improve gradually, in line with rising real disposable income and an improving labour market. The ECB sees risks to growth as evenly balanced in the short term, although it noted that further oil-price rises, global imbalances, and protectionism pose longer-term downside risks.

Outlook and Implications

The ECB has clearly not yet finished raising Eurozone interest rates. Indeed, the fact that the central bank felt compelled to accelerate the pace of monetary policy tightening by acting in August highlights the fact that it is still seriously concerned about the risks to Eurozone price stability over the medium term.

Disturbingly for the ECB, there are currently some signs that persistently high energy prices could be starting to feed through to have some second-round inflationary pressures across the Eurozone. However, while this justifies a further tightening of monetary policy in August, we believe that there are a number of factors that should prevent consumer price inflation from rising substantially over the coming months. Furthermore, there are significant threats to the longer-term growth outlook, which suggest that the ECB needs to be careful about applying the monetary brakes too aggressively. Indeed, if the ECB does act more aggressively, it risks sending the euro markedly higher against the U.S. dollar, which could have very significant adverse repercussions for Eurozone growth prospects.

Eurozone consumer price inflation rose to 2.5% in May, from 2.4% in April and 2.2% in March. Inflation then stabilised at this level in both June and July, which is clearly above the ECB's target of "close to, but just below 2.0%." While the headline inflation rate has been pushed up by oil prices hitting a succession of record highs in 2006, as well as by recently higher food prices resulting from the hot, dry summer, the ECB will have noted that Eurozone core inflation has trended up from 1.3% in February to 1.5% in June. Although core inflation is still within the narrow range of 1.3-1.6% that has existed since mid-2005, its recent firmer overall tone suggests that high energy prices could be starting to filter through to a limited extent. Furthermore, annual Eurozone producer price inflation was at an elevated 5.8% in June (with the core rate rising to 3.0% from 1.5% at the end of 2005), while the output price indices of the Eurozone purchasing managers' surveys for the manufacturing and the services sectors have both been rising markedly recently.

Meanwhile, the ECB remains very concerned by the current strength of money-supply and credit growth across the Eurozone. Although annual Eurozone M3 money-supply growth moderated to 8.5% in June, this was from a three-year high of 8.8% in May. Furthermore, the adjusted three-month moving average for annual M3 only stabilised at 8.7% in June, having originally climbed to this level in May from 8.4% in April and 7.5% in January. Thus, it was 4.2 percentage points above the ECB’s targeted maximum rate of 4.5% in June. In addition, the annual growth rate in loans to the private sector was still as high as 11.0% in June, although this was at least down from a peak of 11.4% in both May and April.

Nevertheless, it remains likely that intense competition amid still relatively fragile consumer spending in a number of Eurozone countries, significant output gaps throughout the region, the strength of the euro, and further wage moderation due to continuing high unemployment will combine to limit the upside for Eurozone inflation over the medium term, which is what the ECB is mandated to focus on. Indeed, the latest Eurostat data shows that annual growth in hourly wage and salary costs across the Eurozone was restricted to 2.5% year-on-year (y/y) in the first quarter of 2006. Nevertheless, this was up from a low of 2.0% y/y in the fourth quarter of 2005, and the ECB will be closely watching to see if pay settlements move significantly higher over the coming months.

Meanwhile, there are a number of potentially significant handicaps to Eurozone growth on the horizon. Indeed, significant doubts persist about the long-term strength of domestic demand in a number of countries, while fiscal policy will be largely restrictive across the Eurozone in 2006 and 2007 (albeit not to the extent in several countries that the ECB feels that it should be, given the state of their public finances).

The recent overall firming in the euro against the U.S. dollar, as well as the very real possibility that it could appreciate markedly further, is particularly worrisome for Eurozone growth prospects. Significantly, the euro hit a one-year high close to US$1.30 in early June, having largely traded around US$1.20 between mid-2005 and March 2006. Although the euro has eased back from this high to currently trade around US$1.28, we expect it to make substantial gains against the dollar over the medium term, as the U.S. Federal Reserve brings to an end its raising of interest rates and the huge U.S. current-account deficit weighs down on the dollar. Meanwhile, persistently very high oil prices are likely to continue to hinder Eurozone growth.

Given the extended squeeze on Eurozone companies' margins from high oil prices, intense competition, and the overall strength of the euro—as well as the awareness that the Eurozone has repeatedly struggled to sustain even relatively healthy growth in recent years—it seems likely that the region's firms will remain relatively cautious about further stepping up their investment markedly and even more reluctant to increase their employment significantly.

While labour markets have recently shown modest overall improvement across the Eurozone, unemployment is still generally very high, and marked, sustainable increases in employment have yet to be achieved. Consequently, consumers are also likely to be cautious about substantially raising their expenditure on a sustained basis. In addition, consumers still have serious concerns about future personal finances in view of potential healthcare, pension, and labour-market reforms in a number of countries. Significantly, consumer confidence across the Eurozone has generally not matched the marked overall strengthening seen in business sentiment since mid-2005, despite reaching its highest level since September 2002 in May. It stabilised at this level in both June and July.

We expect the ECB to raise its key interest rate by a further 25 basis points in both October (to 3.25%) and December (to 3.50%). Thereafter, we forecast the ECB to return to the sidelines in 2007. This is because we anticipate that Eurozone growth will lose some momentum towards the end of 2006 and in 2007, in the face of a forecast marked appreciation of the euro, softer global growth, persistently elevated oil prices, tighter fiscal policy across the region and higher interest rates. Softer Eurozone growth and a stronger euro should alleviate ECB concern over inflationary pressures.

However, we acknowledge that there is a very real risk that the ECB could tighten monetary policy even further than we anticipate over the coming months.