ECB Forecast Change: Hike in July

Overview:

We have changed our rate projection for the ECB in light of the surprisingly hawkish statement made by Trichet on Thursday (5 June) at the ECB press conference and subsequent comments from ECB members. We now expect the ECB to hike rates by 25 bp in July, and thereafter to keep rates unchanged. Earlier we expected rates to be cut by 25 bp in both March and June 2009.

The ECB maintained rates last Thursday but the introductory remarks and especially the statements at the following Q&A session were very hawkish. The ECB is drawing a line in the sand now, and having sounded the warning that interest rates could rise as soon as next month it is hard now not to see the ECB pulling the trigger without risking losing credibility. However, we do not expect a hike in the near future to mark the beginning of a new hiking cycle. In our view, a hike could contribute to an even more pronounced weakening of the economy. Should inflation expectations rise, though, further hikes cannot be ruled out. Uncertainty surrounding our call on the ECB rate is unusually high. Currently we judge the likelihood of a rate hike in July as something like 60-70%.

Details:

Until now we have expected the ECB to be sidelined until spring 2009. On the one hand, we thought the weak growth in itself would curb inflation enough for the ECB to be satisfied. Also weak growth would make it too hard for the ECB to hike rates. Furthermore, ECB credibility has not been suffering. Long term inflation expectations have remained stable and areas of high price increases have been contained. On the other hand, rate cuts are not a reasonable outcome in the short term - inflation is just too high.

With hindsight, it is clear that we underestimated the influence of the hawks in the Council. At the ECB press conference, however, Trichet was very hawkish compared to the previous statement. The ECB is "in a state of heightened alertness" as risks to price stability in the medium term have increased further.

To us Trichet highlighted how close the ECB had been to raise rates already on Thursday by his remarks at the Q&A session. Trichet mentioned that although the decision to leave rates unchanged was unanimous, members of the board did have different views. A number of governing board members were in favour of a hike now, a number were in favour of a hike but not now and some were not in favour of a hike. It was a close call. The ECBs concern over inflation is reflected in the staff projections for inflation which have been raised markedly for both 2008 and 2009. In 2009 inflation is projected to be in an interval of 1.8-3%, thus likely to stay above 2% throughout 2009.

Regarding the next ECB meeting on July 3, Trichet concluded that a rate hike is possible but not certain. "We had a deep exchange of views. We considered that ... that after having carefully examined the situation, we could decide to move our rates (by) a small amount in our next meeting," Trichet said.

Omitting "strong vigilance" blurs the probability of a July hike, and gives the ECB an escape route if economic data disappoint over the next month. However, by floating the idea of an interest rate rise as early as next month the ECB is now under intense pressure to deliver. In recent years "strong vigilance" has meant a decision was already made to change rates at the next meeting. However, on several occasions rates have been changed without ringing the "vigilant" alarm bell. (We have also seen the opposite. For instance, we had a period in 2004 and 2005 where vigilant was mentioned without any changes in rates afterwards. This also happened in August last year when the financial crisis led the ECB to remove the finger from the trigger again and not deliver the hike it had signalled)

On balance we feel the most likely outcome of the ECB meeting on 3 July is an increase in rates by 25 bp. Comments from ECB members after the meeting have also pointed in this direction. ECB member Weber stated after the meeting that "ECB will follow words with action". And another member, Yves Mersch, said that a June hike would have surprised the markets suggesting that this was the main reason why they hadn't hiked already at the June meeting.

However, uncertainties surround the projection. After all the Euroland economy is cooling fast at the moment. Thus until 3 July much new information has become. It is quite natural to ask what it takes for the ECB not to hike rate at the meeting in July. In our view, it takes (in itself or in a combination) either:

• A significant decline in oil prices.
• Very clear-cut signals of a strong deterioration of the growth outlook (relative to the staff projections), eg, a very markedly drop in the ifo.
• Even more clear signals of a stalling French economy and strong signs of a cooling of the German economy.
• Strong indications of a US set-back
• Renewed financial turmoil

To sum up. At the moment we see the chance of a hike to be in the area of 60-70%. Also we expect the cooling of the economy will make the ECB resist any temptation to make further increases in rates. Thus the rate hike the ECB is preparing in July could be labelled cosmetic. If the ECB hikes rates it will indeed be breaking new ground by raising rates in an environment of a clear weakening in growth. It also lays the ground for potential political friction within the monetary union. Challenging times for sure.

In light of the ECB's revealed very strong determination to fight inflation, we have also taken rate cuts out of our forecast. The ECB seems to be willing to accept growth clearly below trend as it feels it has to defend its credibility. We still see a fairly big chance of rate cuts next year as the economy will look very weak but at the moment it doesn't seem quite enough for the ECB to cut rates. It should hold it from raising rates further, though.

Danske Bank
http://www.danskebank.com/danskeresearch

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