Europe: The ECB's Balancing Act

Elga Bartsch | London

So far, tightening monetary policy in the euro area was easy. Coming from a record low of 2% for its main refinancing rate, the ECB Council was unanimously in favour of a gradual withdrawal of monetary stimulus over the last 12 months. Throughout the first year of the new ECB interest rate cycle, inflation and GDP growth forecasts were steadily upgraded providing arguments for nudging interest rates higher. Money markets and ECB watchers, by and large, anticipated the future course of ECB action correctly thanks to a set of code words signaling the timing of the next move. Financial markets took the ECB’s tightening campaign in stride. The common currency grinded higher only gradually, with the brief exception of a more rapid rise in late November. Yields of longer-dated government bonds hovered in a trading range between 3.5 and 4.0% for most of the year. The next 12 months are likely to demand a much more delicate balancing act from the ECB, in our view.

We expect the ECB to hike interest rates further in 2007 — in the light of GDP growth at or above trend, ongoing robust job creation, and rapid money and credit growth. We forecast a total of 50 bps of ECB interest rate hikes by December 2007. This compares with market expectations of slightly more than 25 bps. A total tightening of 50 bps would constitute a noticeable slowdown in the pace of tightening compared with the ‘every-other-meeting’ pace pursued in the second half of 2006. The much more gradual tempo of tightening reflects the fact that the ECB would be pushing the refi rate towards the upper end of the neutral range, which we estimated to be between 3.5% and 4.0%. Even though the inflation outlook isn’t showing significant pressures at present, the risks remain tilted to upside, in the view of the ECB. This perception was emphasised again in the December press conference. Even though that press briefing gave conflicting signals with regard to the timing of the next move, we still believe that the most likely timeframe is March. But by stating that it “monitors risks to price stability very closely” — a phrase that in the past indicated that the next rate hike was only two meetings away — February is a possibility too.

Against this backdrop of further ECB tightening, we expect ten-year Bund yields to rise from the current 3.76% level and eventually break markedly above 4% in 2007. Demand for long-dated bonds, a moderation in nominal GDP growth and pre-emptive monetary policy action will likely limit the rise in bond yields at the far end of the yield curve though. As a result, would not even rule out a renewed inversion of the yield curve in the next 6–9 months. When the spread between the ten-year Bund and two-year Schatz briefly dipped into the red in November, investors debated whether this would signal a recession. This debate could resurface if the spread would move into negative territory again. Historically, the yield curve has been the most reliable leading indicator for recessions. But a number of factors distorting the long-end of the bond market suggest that the message is less clear today (see Debating the Yield Curve, November 25, 2005 by our Global Economics and Strategy Team). These factors range from pension fund demand, central bank buying, compressed term-premia to excess liquidity and/or a savings glut.

The discussion about the ECB’s appropriate policy stance — both within the Governing Council and outside — is expected to become much more controversial in the coming year than it was in the year just ending; for the following reasons: First, at a refi rate of 3.5% euro area short rates are getting closer to the neutral level, which we would deem to be between 3.5% and 4.0%. While there was broad agreement that the bank should gradually take its foot off the monetary accelerator, whether it might need to push interest rates towards the restrictive end of the neutral range (or even higher) will likely be debated much more heatedly. The ECB itself uses a broader concept than just the short rate to assess the stance of its monetary policy. The rapid rate of expansion in monetary aggregates is one of the reasons why it is still regarding its monetary policy as accommodative. Second, the euro economy is likely to enter into a phase where risks to growth are tilted to downside and risks to inflation to the upside. The combination of moderating real GDP growth and intensifying inflation pressures always makes an awkward mix for a central bank. This also holds for a central bank that — like the ECB — gives precedence to inflation concerns.

Third, the ECB might find its policy decisions getting more than the usual amount of unsolicited advice from politicians as France heads for a presidential election, as domestic demand growth cools, and as the currency strengthens. While an independent central bank is unlikely to pay much attention to such broadcasts, this does not make its task any easier, especially in communication with the public at large. Fourth, the two pillars of the ECB monetary policy strategy — the broad-based inflation outlook and the monetary analysis — might soon send diverging signals. The persistent, strong expansion of monetary aggregates will likely continue to signal upside risks to price stability even after the broad-based inflation outlook stopped signaling such risks. Strong money supply growth caused the present tightening campaign to start earlier. It could also cause it to last longer (see EuroTower Insights: The Meaning of Money, November, 13, 2006). Finally, the uncertainty about the near-term economic outlook seems to be on rise at present. The unknowns include whether the US economy will be able to avoid a hard landing this winter, whether the German economy will be able withstand a three-point VAT hike, and whether financial market volatility could show a renewed rise.

A year of challenges. To sum up, the year in which the euro area will welcome its thirteenth member — Slovenia — is likely to hold several challenges for ECB policymakers as the bank’s refi rate approaches the neutral level. Hence, discussions about the appropriate policy stance both within the Council and outside will likely liven up. After a year of successfully micro-managing money market expectations by using a standard set of code words (see EuroTower Insights: Too Much Communication?, May 19, 2006), ECB Council members might start to send much more mixed messages in 2007 as the bank attempts to delicately balance a number of different factors.