Could the European Central Bank Actually Raise Interest Rates?

Published May 5th, 2008 - 07:46 GMT

It has been a very eventful week in Euroland, with a number of ECB speeches and news that the current strong headwinds are increasingly being felt in the economy. The ECB started the week on a hawkish note, with several ECB speakers pointing to rising risks to price stability and hinting that rates might have to be raised. The French central bank governor, Noyer, said, "if needed we'll move rates" to ensure that inflation falls back below 2% next year. This prompted speculation that the ECB might be preparing the markets for a rate hike. Shortly afterwards, however, Noyer claimed that the markets had over-interpreted his comments, and ECB chairman Trichet cemented this view later in the week, saying: "Let me say on the monetary policy stance that we believe that our current monetary-policy stance will contribute to achieving our objective". There is no doubt that the ECB is growing more anxious about the outlook for inflation, but it is also seeing a significant tightening of financial conditions through the strengthening of the euro and higher LIBOR rates on the back of the problems in the money market. The ECB will meet again on 8 May.



Weekly Bank Research Center 05-05-08



 

The Inflation Conundrum

Stephen Roach, Head Economist, Morgan Stanley

Everybody talks about inflation, but market-based measures of inflation expectations have remained remarkably stable. We find this discrepancy between what investors talk about and what they seem to do puzzling. In this note, we discuss two possible explanations for this conundrum. One is that while inflation is currently a concern, most investors trust that central banks will ensure inflation stays in check over the longer term by taking appropriate action. Another is that market-based measures such as breakeven inflation rates may be distorted by crisis-induced buying of nominal bonds and thus do not reflect investors’ true inflation expectations. We present some evidence to suggest breakeven inflation rates are in fact distorted and true inflation expectations may thus be higher. However, we also think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years. Our bottom line: central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.

 

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European Central Bank: Still Hawkish

Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

It has been a very eventful week in Euroland, with a number of ECB speeches and news that the current strong headwinds are increasingly being felt in the economy. The ECB started the week on a hawkish note, with several ECB speakers pointing to rising risks to price stability and hinting that rates might have to be raised. The French central bank governor, Noyer, said, "if needed we'll move rates" to ensure that inflation falls back below 2% next year. This prompted speculation that the ECB might be preparing the markets for a rate hike. Shortly afterwards, however, Noyer claimed that the markets had over-interpreted his comments, and ECB chairman Trichet cemented this view later in the week, saying: "Let me say on the monetary policy stance that we believe that our current monetary-policy stance will contribute to achieving our objective". There is no doubt that the ECB is growing more anxious about the outlook for inflation, but it is also seeing a significant tightening of financial conditions through the strengthening of the euro and higher LIBOR rates on the back of the problems in the money market. The ECB will meet again on 8 May.

 

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U.K. Economy Slows Further

E. Silvia, Ph.D. Chief Economist, Wachovia

Real GDP growth in the United Kingdom has been slowing since the middle of last year. Indeed, the 1.6 percent annualized growth rate that the economy eked out in the first quarter was the slowest sequential growth rate in three years. What is behind the slowdown in British growth, and what does the future hold? A detailed breakdown of the first quarter growth numbers is not yet available, but monthly statistics offer some clues. Indeed, housing starts are currently running 10 percent below last year’s levels, and anecdotal evidence suggests that non-residential construction is starting to weaken. Therefore, construction probably weighed on growth in the first quarter. International trade may have exerted a slight drag on growth in the first quarter, reversing the positive contribution in the previous quarter. Monthly trade statistics show that the volume of imports rose in the first two months of the year relative to the fourth quarter of last year. In addition, growth in industrial production, which has not been very strong over the past few years anyway, weakened a bit more in the first quarter. That said, the manufacturing PMI remains above the demarcation line of “50”, which suggests that industrial activity is hardly collapsing at present.

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Fed Cuts a Quarter-point: Sees Risks Balanced

Steve Chan, Economist, TD Bank Financial Group

The Federal Reserve last week cut interest rates an additional quarter point, bringing the fed funds rate to 2.00%. Their statement generally left their descriptions unchanged for the economy (negative) and inflation (uncertain with a touch of hope). They did remove their mention of downside risks, which could imply they feel the level of interest rates is appropriate to balance the desire for moderate economic growth in the future with the risk of stoking inflation. In the near term, we may see the Fed pause to see how the economy reacts to 325bps of interest rate cuts over the last eight months – as well as $100bn in tax rebate checks. However, 325bps in interest rate cuts have translated into less than 75bps in cuts to 30-year mortgage rates and less than 25bps in cuts to rates on new car loans. We fear further economic weakness will warrant more easing, bringing the target rate to 1.25% by year-end. The Fed on Friday announced an expansion of liquidity operations aimed at increasing the pass- through into lower consumer loan rates, but they have yet to find the right mix of ingredients in their cauldron to cure what ails the economy.

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A Strong Dollar Could Pressure the EM Currencies

Trevor Williams, Chief Economist at Lloyds TSB Financial Markets

Over the past few months we have seen a weak US dollar and a strong euro coupled with a decline in equities and strength centred on the eastern European currencies. However, in recent weeks I have changed my view of the US dollar to bullish and euro to bearish, with a broad inversion of past trends. This scenario has filtered through to the emerging market currencies with clear signs of weakness in the previously bullish PLN, CZK, HUF and RUR. Whilst this is evident in the short term, it could be that we are at the beginning of a medium term (1-3 month) change in trend. With commodities continuing to weaken, there is further scope for a move back upwards for the dollar against the BRL,CLP and COP with an increase in volatility a key feature.

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