Euroland: Of Dogs That Bark and Bite
Elga Bartsch (London)
morganstanley.com
“To the curious incident about the dog in the night time…”
“The dog did nothing in the night time.”
“That was the curious incident.”
remarked Sherlock Holmes.
The Adventures of Silver Blaze
Sir Arthur Conan Doyle, 1892
In our view, the ECB will not just bark, it will also bite
In one of the most famous Sherlock Holmes stories, the Adventures of Silver Blaze, the crucial clue is a curious incident of a dog that did not bark in the night. The absence of a bark from the stable watchdog leads Sherlock Holmes to conclude that the theft of the racehorse at the centre of the murder mystery, Silver Blaze, was an inside job. It turned out it was and the mystery was swiftly solved. In the case of the ECB, many modern-day financial-market Sherlocks believe that the ECB barks so it doesn’t have to bite. We disagree. In our view, the ECB will likely keep barking, but it will also bite. And it will likely bite sooner rather than later. We have highlighted for some time that the risk of early ECB rate hike is rising. We now think that ECB is likely to start hiking rate before year-end. We thus bring forward our long-held view for a first rate hike of 25 basis points in 1Q06 to 4Q05.
We now believe that the ECB will hike before year-end
After the strong language used at the Athens press conference by ECB President Trichet, which in our view has clearly opened the door for an early ECB rate hike, we can’t completely dismiss the risk that the ECB Council decides to hike rates already at the upcoming ECB Council meeting on November 3. While we would not rule out such an early move in response to buoyant business survey, stubbornly high money supply growth and elevated consumer price inflation, we would only deem it an outside scenario. We believe that a move in December is more likely. For two reasons:
In our view, it’s likely that so far only a minority or a narrow majority of Council members is in favour a rate rise. Because the ECB likes to take its decision by a broad consensus rather than a narrow majority it will likely take time to convince those members who still seem to be resisting a rate hike.
Furthermore, at the December meeting the Council will also have a fresh set of ECB staff projections to ponder. Compared with the September projections, they should show upwardly revised growth and inflation numbers from the central projections for 2005 and 2006, which stood at 1.3% and 1.8% for GDP growth and at 2.2% and 1.9% for HICP inflation. In addition, the bank’s staff will release 2007 estimates. These will likely show a continued economic recovery with GDP growth likely showing a two-handle, say 2.25%, and probably a slight drop in HICP inflation towards the ECB’s inflation ceiling, say to 1.75%.
Further tilt towards upside risks to price stability
For starters, the Council has now more signs of a robust recovery in the euro area compared to the October meeting. Based on our proprietary indicators, GDP growth could be as high as 0.75%Q in 3Q and near a robust 0.5%Q in 4Q (see Euroland Business Cycle Watch: Dismissed from the Emergency Ward, October 28, 2005). Two quarters of above-trend growth in the euro area should suffice to inspire enough confidence in the ECB Council to embark on a gradual tightening campaign. Incoming monthly indicators such capital goods orders and business sentiment suggest that euro area capex has started to pick up in recent months while retail sales and car registrations hint at a surprisingly healthy consumer spending growth this fall. Downside risks to growth from high oil prices, cited at the Athens press conference, also dissipated at least partially.
As headline inflation will likely spill into core HICP
In addition, HICP inflation remains elevated at a level described by ECB President Trichet as significantly in excess the ECB’s definition of price stability. Eurostat’s flash estimate released late last week put Euroland inflation at 2.5% after an upwardly revised 2.6%Y in September. Indication from the break-down of the German state CPIs, the preliminary Italian CPI, and our own top-down forecasts for euro area would suggest that core inflation has likely ticked higher in October. True, at 1.4%Y, on our forecasts, core inflation is still subdued. However, experience has shown that core inflation tends to follow headline with three quarter lag. Hence, even if headline inflation was to peak out in early 2006, as our current inflation profile suggests, core inflation will likely rise well into the summer months.
As money supply and credit growth accelerate
Next to that, excess liquidity keeps piling higher. September M3 money supply growth accelerated further to a higher than expected 8.5%Y. This brought the 3MMA up to 8.2%, from 7.9%% in the previous three-month period. As before, strong money supply growth went hand in hand with a strong growth rate in credit to the private sector. At 8.6%, lending to private sector suggests that it is bank lending rather than portfolio shifts boosting money supply growth. Recently, M3 money supply growth corrected for portfolio shifts has started to show a more vigorous revival than overall M3. Judged against a more robust economic recovery these strong money supply figures are becoming even more of a worry with regards to the long-run upside risks to price stability. The likelihood of some of the excessive liquidity finding its way into spending is clearly on the rise.
Warrants more than just strong vigilance by the ECB
As a result, we expect the ECB Council at the very least to adopt an even more hawkish language than at the last press conference. Hence, at the very minimum the “strong vigilance” regarding the upside risks to price stability used in the introductory statement to the October press conference, will likely be raised to “extreme vigilance”.
Firmly anchoring inflation expectations …
A lot in monetary policymaking depends on inflation expectations. So far, euro-area inflation expectations have remained relatively well contained. But there is no mistaking the upward trend in euro-area inflation expectations. The only exceptions are the breakeven inflation rates embedded in the bond market, which have even eased slightly back to 2.1%. However, from ECB’s standpoint these market-based inflation expectations also reflect certain expectations as to the future course of action taken by the central bank. In the case of the ECB, money markets are currently expecting 65 basis points of rate hikes by the end of 2006 and the probability of an ECB rate hike before year-end is as seen equivalent to the flip of a coin. Hence, if the ECB doesn’t deliver on these expectations, the danger is that break-even inflation rates start to creep higher.
… might require more than just words
In euro area business surveys, selling price expectations remain above average in manufacturing and construction. National data suggest that selling price expectations snapped back in retailing. In consumer surveys, the net balance of households expecting prices to rise in the coming 12 months has increased again in October, the second consecutive rise after a temporary dip in August. There is no mistaking the upward trend in consumers’ inflation expectations. Inflation expectations among ordinary Eurolanders, who the ECB had found in past to be decent forecasters of future inflation trends in the euro area, have more than doubled since the beginning of the year (see M. Forsells and G. Kenny, Survey Expectations, Rationality and the Dynamics of Euro Area Inflation in Journal of Business Cycle Measurement and Analysis, Vol 1 (2004), No. 1, 13-41). In our view, the ECB cannot afford to wait until these higher inflation expectations start to spill into higher wages and salaries. There are some signs that trade unions are becoming more assertive again. In Germany, for instance, the still powerful IG Metall has proclaimed the end of modesty after the current contract for more than 2.4 million employees in the metal sector expires at the end of February. Average wage demand in the last ten years was near 6%, the average settlement typically half of that. This would clearly mark an increase from the previous 2.2% pay-rise.
Bottom line: A first rate 25 bp hike in December
Unless the EUR unexpectedly starts to rally sharply or the economic recovery suddenly falters, we expect the ECB to hike the refi rate by 25 basis points in at the Council’s December 1 meeting. After 29 months of unchanged interest rates in the euro area this would mark the first ECB rate hike since October 2000. Given the recent upside surprises in business sentiment, consumer price inflation and money supply growth, we would not completely dismiss the idea of a rate hike at the November meeting. But, on balance, we deem a move at the December meeting more likely. Likewise, we believe that the first rate hike is more likely to be a small one of 25 basis points rather than a big one of 50 basis points. True, at the beginning of the last tightening cycle in November 1999, the ECB took its previous 50 basis point cut from April 1999 back in one go. But, at that time, the ECB wanted to stem against rapidly depreciating currency. This time around, the Bank might want to leave market expectations for further rate hikes intact in order to contain medium-term inflationary pressures. |
