ECB Hikes and Keeps Options Open

• Interest rates rise but ECB attempts to calm markets
• Mr. Trichet keen to avoid any signal of further rate increases
• Euro area economy entering into a period of extreme conditions
• Growth set to slip and inflation likely to rise in coming months
• Uncertainty about the outlook, divisions within the ECB and a desire not to 'spook' financial markets lead Trichet to strike a soothing note

Why are interest rates rising when economies are weakening?

William McChesney Martin, the head of the US Federal Reserve between 1951 and 1970, famously said that the job of a central bank 'is to take away the punch bowl just as the party gets going'. In terms of the European economy at present, today's ¼ per cent rate rise by the European Central Bank comes however against a background of sharply weakening economy.

Martin's comments are worth recalling because they underscore how unusual current circumstances are. Traditionally, interest rates rise because booming economic conditions threaten to spill over into runaway inflation. Nowhere in Europe is booming at the moment and while the German economy is proving stronger than expected, leading indicators are pointing towards a marked slowdown. This will compound notably slower growth in countries like France and potential crisis in economies like Ireland, Spain and Italy. Unfortunately, weakening economic conditions are becoming established at a time when intense upward pressure on commodity costs threatens a knockon increase in a broader range of prices. Given a mandate that charges it with maintaining price stability, the European Central Bank has judged that higher interest rates are required to guard against the threat of persistently high inflation. Of necessity, this implies much greater risks in the near term of notably weaker activity across the Eurozone.

So, current conditions are extremely unusual and difficult. They are altogether different from the traditional cycle in which strong activity prompted inflation risks and a response of higher interest rates whereas weak economic conditions would bear down on inflation and lead to lower interest rates. Earlier today, purchasing managers data for the Eurozone, a leading indicator of activity across the single currency area dropped to their weakest level since June 2003 (see Diagram 1). In that month, five years ago, the ECB also altered policy. Interest rates were cut by 50 basis points to 2.00%. In stark contrast, even after today's ECB rate rise, the powerful combination of credit crunch and commodity prices increases mean markets fear borrowing costs are set to rise further.

Where next for ECB rates?

Having raised interest rates today, it appears the key signal that the ECB wanted to send is that it is not mechanically set on a sequence of rate increases. That said, Mr. Trichet's language was extremely carefully chosen to provide the ECB with maximum room for manoeuvre. So, although there was a clear intention to calm market fears, there was no commitment that rates will not rise again in the months ahead.

Probably the strongest comment Mr. Trichet made was to say that the ECB 'has no future bias' but in response to questions he repeatedly emphasised that 'the ECB does not pre-commit'. He also noted that 'we will communicate in a clear way on future decisions'. So, we can be fairly sure that the ECB doesn't intend raising rates in August but, beyond that, the ECB is keeping its options open.

Looking through today's opening press statement, the absence of the phrase 'heightened alertness' is also clearly intended to defuse any threat of further near-term rate increases. Here again, Mr. Trichet was at pains to suggest that there was no major significance in its absence. Similarly the re-introduction of the phrase 'the monetary policy stance following today's decision will contribute to achieving our objective' of price stability is intended to soothe market nerves but as this phrase also appeared in the May ECB statement it doesn't give much of a guarantee that rates won't rise further in the Autumn. Finally, it is noteworthy that Mr. Trichet did not repeat previous comments that 'the ECB is not signalling a sequence of rate hikes.' So, again this suggests today's press conference is very much a case of attempting to calm markets by avoiding any threatening comments but being careful to avoid any definitive promise not to raise rates further.

Why is the ECB hedging its bets?

We think there are three distinct and important reasons why Mr. Trichet struck a notably less threatening note today. First of all, uncertainty about the outlook for the Euro area economy is increasing. Mr. Trichet was at pains to point out that the second and third quarter growth data would not be good, an outturn clearly suggested by the emerging trend in forward looking indicators such as the data shown in Diagram 1. However, the weakening in activity and sentiment in the past month has probably been greater than the ECB expected. With Euro area businesses and consumers having to deal with even higher fuel bills, a rising Euro and more expensive borrowing costs of late, the risk of a further step-down in activity is not insignificant.

Unfortunately, it seems likely that inflation could edge up to 4.1/4.2 in August/September and financial market expectations of inflation are also drifting higher. So, from the ECB's perspective the risk of poorer activity is more than countered by the threat of an even nastier inflation outlook in coming months. If inflation risks increase further, the stance taken by the ECB in the past month will fuel expectations of a further interest rate response. So, the dilemma facing the ECB may well worsen. In such circumstances, Mr. Trichet is understandably reluctant to give any hostages to fortune by sending an unambiguous signal on future policy.

A second reason why the ECB may have adopted the approach taken today is the strong probability of continuing divisions within the Governing Council. Mr. Trichet did say that today's decision was unanimous but it is most unlikely that the different opinions he acknowledged openly a month ago have now disappeared. Indeed, the combination of weakening activity and rising inflation may have increased these divisions. It could be suggested that the 'doves' won a delay in the sense that action was not taken in June but this was more than offset by a statement that emphasised the views of the more hawkish members of the Council. Today, when the ECB's action in raising rates reflected the views of the 'hawks', it is scarcely surprising that some concessions were made to the doves in terms of a somewhat softer tone to the monthly press conference. We will learn more when we hear the views of individual Council members in coming days. It was notable that after the June press conference, Mr. Weber, who is perceived to be the most hawkish member of the Governing Council land out far more clearly than Mr. Trichet that 'actions must follow words'. It will be instructive to see how Mr. Weber's words follow today's actions. Will he strike a still threatening note?

A third argument for a relatively dovish press conference today is increasingly nervous conditions on financial markets. Today's developments in Frankfurt coincided with the release of another poor set of jobs data in the US and another record high for oil prices. Against this backdrop, any signal that the ECB was set on an aggressive path of interest rate increases could have sparked a sharp sell-off in equities or let to increased volatility in currency markets. So, Mr. Trichet would have been very keen to avoid being blamed for further convulsions in financial markets.

In this regard, developments in the past month might have convinced the ECB that strong action must be accompanied by soothing words. Although, today's rate rise has been taken calmly by financial markets, there is little question that the ECB is following a risky strategy. It is not unique in this regard. Critics of the US Federal Reserve argue that by its inaction it is taking significant risks with inflation and the long-term health of the US economy. However, an argument could be made that by raising interest rates at a particularly sensitive time for the global economy and financial markets, the ECB risks making things worse rather than better. Following the ECB's early June signal that it intended to raise interest rates, oil prices rose by nearly $17 per barrel in two days. This largely reflected pressure on the US Dollar resulting from the combination of tougher ECB talk and weak US employment figures. The immediate impact today of an ECB rate rise and another set of weak US jobs data has been less threatening. So, the ECB will be pleased with financial markets immediate response to today's developments. That said we feel a definitive judgement will not emerge for some time.

What happens next?

In coming months persistent inflation worries may make markets fear more aggressive ECB action. We still think there is a strong possibility of a further ECB rate rise in September or October. This threat will keep yields under upward pressure for now, despite yesterday's 'buy the rumour, sell the fact' movement.

Further out a sharp economic downswing may force the ECB to reverse course and cut rates significantly during 2009, but that now appears a very distant possibility.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.