ECB Fires A Shot Across the Bow

After signaling in June the likelihood for higher interest rates, the European Central Bank carried through with their insinuations and raised rates by a quarter point, bringing the Eurozone refi rate to 4.25%. In the June press conference, President Jean-Claude Trichet announced a "state of heightened altertness" which he said meant a rate hike was possible but not certain. However, since last month, Eurozone inflation accelerated from 3.6% in May (which was subsequently revised up to 3.7%) to 4.0% in June, while oil prices rose another 15 per cent. This made an increase in rates in July nearly a foregone conclusion.

In the press conference that followed, Trichet explained that the move will serve to "prevent broadly based second-round effects and to counteract increasing risks to price stability over the medium term." While the ECB assumes the Eurozone will see a "protracted period of high annual rates of inflation," their principal concern is controlling price and wage setting behavior and "guaranteeing price stability in the medium term." The concern is that higher food and energy prices could lead wages and other prices in the economy to rise and embed an expectation for higher inflation in the future. While one rate hike will have very little effect on inflation itself, the ECB hopes this warning shot will show that it is serious about its mandate to keep the pace of inflation below but close to two percent in the medium term.

The risks for inflation are tenuously balanced with the ECB’s assessment that "downside risks to [the] economy prevail," but are surrounded by a "high uncertainty." The ECB did not signal any imminent change in interest rates in the coming months, saying "the monetary policy stance following this decision will contribute to achieving our objective." This does not rule out another rate hike this year if oil prices continue to rocket skyward. However, the fact that the ECB expects inflation to moderate only gradually in 2009 suggests that they are expecting oil prices to moderate very little over the next few months. Our expectation is that oil prices could fall about 25% by year-end, which would help bring Eurozone inflation close to 2% by the end of 2008. However, if oil prices were to average $140pb through the first quarter of 2009, Eurozone inflation would likely peak near 4.3% in August but fall to around 2.5% by March 2009 - an outcome we think would be acceptable to the ECB given concerns economic growth will be much slower in the second half of this year. Oil would have to average more than $140pb in the coming months or rising core inflation would have to push headline inflation beyond that expected August peak in order for us to expect another ECB hike. We continue to expect that the ECB will remain at 4.25% for the rest of 2008 and will deliver cuts in March and May of 2009 to bring interest rates down to 3.75%.

TD Bank Financial Group

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