IHS Global Insight Perspective | |
Significance | Although the European Central Bank (ECB) kept its interest rate unchanged at 1.25% at its June meeting, it indicated another increase to 1.50% at its July meeting. |
Implications | Classic clues of a July increase were wheeled out by the ECB, most notably the repeated observation that "strong vigilance is warranted" with respect to maintaining price stability over the medium term. This is the trigger phrase that the ECB has frequently used in the past to indicate that interest rates will rise at its next policy meeting, as was the case with its April increase from 1.00% to 1.25% |
Outlook | IHS Global Insight has little doubt that the ECB will deliver on its hints in July and enact a 25-basis-point increase to 1.50%. Further ahead, we see one more increase this year, to 1.75% in the fourth quarter, while we expect the ECB to continue to raise interest rates gradually in 2012, taking them up to 2.50% by the end of next year. |
The European Central Bank (ECB) kept its key Eurozone interest rate at 1.25% at the conclusion of its 9 June policy meeting, having previously raised it by 25 basis points from 1.00% at its April meeting. Prior to April's increase, the ECB's key interest rate had stood at 1.00% (the lowest level since the Eurozone came into being in January 1999) since May 2009. This was the consequence of the ECB reducing interest rates by 325 basis points between October 2008 and May 2009 as the Eurozone faced extended, deep recession.
Although the ECB kept interest rates unchanged at its June policy meeting, the bank left little doubt that it will raise its key interest rate from 1.25% to 1.50% at its July meeting. Not only did the ECB observe twice in its June policy statement that "strong vigilance is warranted" with respect to maintaining price stability over the medium term—its trigger phrase to signal an imminent interest-rate rise—but president Jean-Claude Trichet indicated that such a move "might happen" in July. It is also notable that the ECB's policy statement did not mention that interest rates are at an "appropriate" level, and it indicated that the bank will act in a "firm and timely manner".
Further ahead, the ECB left its policy options fully open. Trichet commented in his press conference that, "We are not signalling any particular pace for the next decisions on our interest rates." He also stressed that the ECB never pre-commits to future policy decisions.
The ECB noted that there is continued upward pressure on overall Eurozone consumer price inflation, which at 2.7% in May is clearly above the ECB's target rate of "close to, but just below, 2.0%". Although this is primarily due to elevated energy and commodity prices, the ECB also observed that upward pressures are discernable in the earlier stages of the production process. It also considers that Eurozone consumer price inflation rates are likely to stay above 2.0% over the coming months.
The ECB regards it as imperative that households' inflation expectations and companies' pricing expectations are contained so as to ensure that currently elevated Eurozone consumer price inflation does not feed through to have significant second-round effects. Moreover, the ECB obviously believes that the best way to contain inflation and pricing expectations is by raising interest rates again sooner rather than later, thereby sending out the message that it is not willing to take risks on the inflation front despite significant Eurozone growth uncertainties and the problems of Greece, Portugal, Ireland, and to a lesser extent Spain.
The ECB acknowledges that Eurozone growth was lifted in the first quarter of 2011 by special factors and will slow in the second quarter. The bank expects Eurozone economic activity to continue at a solid but unspectacular rate going forward, with the central Eurozone GDP growth forecasts of its staff standing at 1.9% for 2011 and 1.7% for 2012. The ECB sees elevated uncertainties still around this outlook but believes the risks to be balanced.
Despite indicating that an interest-rate rise is very much on the cards for July, the ECB decided at its June policy meeting to extend its emergency liquidity operations. One-week, one-month, and three-month funding operations are being continued with full allotment and fixed interest rates until at least mid-October. This reflects the still high dependence on ECB funding by banks in the more vulnerable Eurozone countries. Any near-term withdrawal or reduction of these credit facilities risks damaging the operations of banks in these countries and hence economic growth prospects. This extension of the emergency liquidity operations highlights the decoupling of standard and non-standard ECB policy.
Outlook and Implications
We have little doubt that the ECB will deliver on its hints in July with a 25-basis-point increase from 1.25% to 1.50%. Further ahead, we see one more increase this year, to 1.75% in the fourth quarter. We expect the ECB to continue to raise interest rates gradually in 2012, taking them up to 2.50% by the end of next year.
We believe that bumpy and modest Eurozone growth overall will lead to ECB caution over raising interest rates aggressively. Although Eurozone GDP growth picked up markedly in the first quarter of 2011, the ECB is very aware that major economic and financial handicaps remain to the development of sustainable, robust growth. Indeed, latest data and survey evidence suggest that Eurozone growth has lost some momentum and relapses in economic activity will remain a very serious risk for some time to come. In particular, tighter fiscal policy will increasingly bite across the Eurozone as 2011 progresses. Furthermore, the tightening will be aggressive in a number of Eurozone countries as a consequence of the sovereign debt crisis.
Furthermore, even modestly higher ECB interest rates threaten to add to the growth problems of Greece, Ireland, Portugal, and even Spain. Meanwhile, recurrent Eurozone sovereign debt crises could increasingly weigh down on business and consumer confidence, thereby dampening activity. On top of this, there are currently significant global economic uncertainties resulting from events in the Middle East and North Africa, and their impact on oil prices.
Nevertheless, pressure for further ECB action is stemming from the possibility that Eurozone consumer price inflation will rise further in the near term despite easing back to 2.7% in May from a 30-month high of 2.8% in April. This is appreciably above the ECB's target rate of "close to, but just below 2.0%". Furthermore, the ECB will see the rise in core Eurozone inflation to 1.8% in April from 1.5% in March and 1.1% in February as a sign that high energy and commodity prices are increasingly feeding through to have second-round inflationary effects. This is something that the ECB is determined to prevent happening.
Despite spiking up recently, core Eurozone inflation should still be relatively modest over the medium term, and it remains probable that Eurozone consumer price inflation will fall back later in 2011 and will be in line with the ECB's target rate over the medium term. Supporting this view, the adjusted three-month moving-average growth rate for annual Eurozone M3 money supply was still only 2.1% year-on-year (y/y) in April, which was less than half the ECB's targeted rate of 4.5%. Furthermore, although there was a modest overall pick-up in the first four months of 2011, growth in loans to the private sector was still limited to 2.6% y/y in April, primarily because loans to non-financial corporations only edged up by 1.0% y/y. This maintains concern that Eurozone growth could be held back by a significant number of companies being unable to obtain the credit they need.
Admittedly, the European Commission's business and consumer confidence survey shows that consumers' inflation expectations were still above long-term norms in May after surging in early 2011, but they have eased back after peaking in March. Furthermore, elevated consumer inflation expectations seem unlikely to fuel markedly higher wage growth in most countries, given high unemployment. Therefore, it remains unlikely that a damaging upward wage-price spiral will develop. Moreover, although companies' pricing expectations have also risen, we suspect that they will find it increasingly difficult to make significant price rises stick, given likely limited Eurozone growth and the pressure on consumers. In fact, the European Commission's survey showed pricing expectations among companies falling back in all sectors in May except for retailing.
Meanwhile, ongoing difficulties for some Eurozone banks means that the ECB is likely to have to tread very carefully in the withdrawal of its current emergency liquidity measures. Indeed, the ECB announced at its June policy meeting that it would extend all of the current measures through to at least mid-October 2011. We suspect that it may need to maintain at least some of the measures after that date.