Euroland: Tough Choices for the ECB
Joachim Fels (London)
Comments by ECB council members suggest that the Bank is not overly concerned about the euro’s rally, which has now taken EUR/USD up by more than 5%, and the nominal effective exchange rate up 2.5%, since the end of August. Rather, officials appear to welcome a stronger euro as it partly offsets the steep rise in oil prices and dampens inflation pressures. And, according to an unnamed senior euro zone monetary official quoted by Reuters this Thursday, it “probably” allows the ECB “to wait a little while longer” before raising interest rates. In my view, however, a policy that allows an already overvalued euro to appreciate further and at same time maintains negative real interest rates could create serious instabilities for asset markets, the real economy and prices.
Endorsing a further euro appreciation in order to cushion consumers against higher oil prices is problematic for two reasons. First, it implies that part of the burden from higher oil prices is shifted from consumers to exporters. Experience suggests that a sharp (exogenous) euro appreciation not only dampens export growth but also has an almost immediate impact on corporate production and investment decisions. Thus, an unchecked euro appreciation risks to hamper or even abort the nascent capex recovery in the euro area.
Second, on most of the many valuation models that our currency team maintains, the euro is already significantly overvalued against the dollar (the median fair value produced by the models is $ 1.08). Allowing fx markets that see the US current account deficit as a major problem (in my view, wrongly so) to drive the euro higher and higher, risks a sharp correction of exchange rates in the future. A central bank should not contribute to exchange rate volatility but rather try to dampen it. And that is still what I expect the ECB to do eventually, if the euro were to rally sharply further. The perhaps greatest success of Jean Claude Trichet since he became ECB President almost exactly one year ago (Happy Anniversary, Monsieur le President!) was his verbal intervention on the euro early this year, which stopped the euro’s rally just below $1.30. In my view, verbal intervention would resume if the euro broke above the $1.29 high from last February and, if that didn’t help this time round, overt dollar purchases by the ECB would follow from $1.35 or so. But given the recent comments by several council members suggesting a kind of ‘benign neglect’ with respect to the euro’s rally so far, I am far less certain about the ECB’s response than I was last January (see EuroTower Insights: The ECB’s Dilemma, 2 January 2004).
Another pitfall for the ECB is that the euro appreciation appears to have reduced the Council’s appetite for ending its policy of maintaining negative real interest rates in the foreseeable future. As the (again) stronger-than-expected money supply and bank lending data released this week should have made abundantly clear, rock-bottom official interest rates are fuelling excess liquidity and credit growth. Mortgage lending to private households, by far the biggest component of bank lending, accelerated to an annual growth rate of 9.8% in September. Also, the acceleration of M3 growth from 5.5% to 6.0%Y illustrates the ECB’s analysis in the October Monthly Bulletin that the recent dynamics of underlying monetary growth has picked up steam, and M3 growth can longer no be predominantly ‘explained away’ with portfolio shifts. The longer interest rates are kept artificially low, fuelling excess liquidity growth, the greater will be the risk of price bubbles in euro area real estate markets, bond and equity markets, as well as in those countries that peg their currencies to the euro. Asset bubbles, in turn, raise the two-way risk to consumer prices, on the upside as long as the bubble inflates, and on the downside when it bursts. Thus, as in the case of the exchange rate, the ECB risks creating future instabilities in asset markets, the real economy and prices, if it continues to sit on its hands doing nothing about interest rates.
So much for the ‘what if’ analysis. But what is the ECB likely to do on interest rates? The key swing factor at this stage is the euro, in my view. Let’s consider three euro scenarios. First, if the euro were to rally further and makes new highs in the coming weeks, the first rate hike that the ECB Council has been mulling in recent months and that we have been expecting to occur in December, would likely be shelved until further notice. At the same time, as described above, I would expect the ECB to start leaning against too sharp an appreciation, verbally initially and, if necessary, also by overtly buying dollars. Second, if the euro settles in the $ 1.25-1.29 range, I still see a 50:50 chance of a December rate hike, based on rising concerns about excess liquidity and the longer-term consequences for asset markets and consumer prices. Third, if the euro eases back below $ 1.25, which is still our currency team’s main case, I continue to expect a first rate hike in December. As a justification, the ECB would probably point to the risk of inflation remaining above 2% in 2005 and 2006 (2006 staff projections will be released for the first time in December) in the light of the higher oil prices and stronger monetary growth. Yes, I’m probably the last one out still looking for an ECB rate hike this year, provided the euro eases back a bit. But I’m hanging in there, watching the euro.
morganstanley.com
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Is this guy off the wall or what?
He wants Europe to raise interest rates in spite of the fact that he thinks the Euro should be at 1.08 and inflation only at 2%. He expects Trichet can talk down the Euro in the face of these hikes and even suggests that Europe might overtly buy US$ to hold down the value of the Euro. With inflation running at 2% in Europe and no consumer demand to speak of in Germany (and now Italy), he hinks a hike is needed to prevent inflation.
Amazing
Oh well here is a viewpoint if anyone cares to comment
Mish |
