ECB: Rate Hike but Remarkably Cautious

Overview:

The ECB raised rates on 3 July by 25 bp to 4.25%, which came as no surprise. As we expected, there was a much more balanced approach in both the introductory statement and the question and answer session than there was in June; the committee used milder language in order to ensure it did not feed expectations of more rate changes.

Details:

This time the ECB expressed much more concern about the growth picture by reintroducing references to downside risks to growth, omitting upside risks and by expressing its "expectation of rather weak real GDP growth in the second quarter of 2008, in part as a technical counter-reaction to the strong quarter- on-quarter increase of 0.8% in the first quarter". In addition, growth was to be "more moderate" instead of "slower". Also, in the question and answer session, Mr. Trichet even mentioned that growth rates were not flattering.

By dropping the phrase "heightened alertness" and reintroducing "monitor very closely all developments ..." in the introductory statement, the Bank clearly did not wish to encourage market expectations of further hike(s). Also, it mentioned that inflation is "likely to remain well above 2% for some time to come" which is a remarkably softer tone than in the June statement, in which inflation was said to "remain above 3%". Mr. Trichet mentioned that the "decision (to hike rates) was taken to prevent broadly based second-round effects and to counteract the increasing upside risks to price stability over the medium term". Although the hike does contribute to an even more pronounced weakening of the economy in our view, the move is largely a symbolic gesture aimed at getting inflation expectations down.

By repeating that the ECB never pre-commits Mr. Trichet did not rule out future changes in the leading rates in light of the incoming data over the coming months. "We do what is necessary and that is what we did today", he said.

Assessment and outlook:

The signal the ECB sent out is that it is serious about its anti-inflation mandate, although markets were little changed after the decision as it was widely expected. However, in line with our expectations the ECB took a balanced approach while still leaving the door open for future changes in rates. As a result both 2-year and 10-year rates have declined markedly. 2-year government bond yield rates dropped by approximately 25 bp while 10-year bond yields declined by approximately 10 bp. We agree with the market's interpretation. The ECB remains must balance dwindling growth prospects with downside risks and high inflation against upside risks and fear of second-round effects. We expect the ECB to keep rates on hold until the end of 2009. However, the uncertainty surrounding our call on the ECB rate is unusually high.

Danske Bank

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