ECB in Uncharted Waters

Daily Forex Fundamentals | Written by KBC Bank | Jul 02 08 07:53 GMT

• ECB to hike rates at a time economic growth is faltering
• Persistent upward pressure on food and energy prices drives inflation expectations higher
• Increasing signs of second round effects in the labour market and the services sector
• Global recession needed to bring inflation down?

At its monetary policy meeting on Thursday, the ECB governing council is virtually certain to hike rates for the first time since June last year to 4.25%. At its early June press conference, ECB's Trichet surprised friend and foe by openly hinting at a 25 bps increase at their next meeting in July. With inflation remaining high for a more protracted period than previously thought, rising inflation expectations and possible signs of second round effects in the labour market and the services sector, the ECB said it had moved to 'a state of heightened alertness'. Hence, a majority of the ECB governing council concluded that a forceful signal was needed to defend the ECB's inflation-fighting credibility.

If a rate rise this Thursday seems inevitable, than the main question is what will happen next. Will one rate hike be sufficient to bring inflation down in the medium term or will more follow. Until now, the ECB has repeatedly argued that this is 'not the beginning of a series of rate increases', but as inflation is expected to rise further over the summer, markets currently expect rates to rise again at the end of this year and in the first quarter of next year.

The problem for the ECB and for European borrowers is that price pressures seem to be increasing while the economy is heading in the opposite directions. Indeed, rising food and energy prices threaten to push inflation above the magic 4% level over the coming months, despite increasing signs that the euro zone economy is faltering. In June, the PMI surveys both in the manufacturing and services fell below the 50 mark, which suggests that economic activity is contracting in the euro zone. Historically, these low levels of business confidence corresponded with an easing policy of the ECB (see graph) and as such highlight the extreme situation we're currently in.

Recent weak eco data however don't appear to have softened the ECB's concerns on inflation. During his testimony before EU parliament last week, Trichet sounded increasingly concerned about the risk that current elevated inflation rates will become entrenched in private inflation expectations and lead to second-round effects in price and wage setting behaviour. He went on saying that the 'risk of triggering such an inflationary wage-price spiral is particularly acute, especially in countries where nominal wage indexation schemes exist'. These phrases will probably be repeated in the introductory statement on Thursday and emphasize the risk that one small rate hike in July won't be sufficient to bring inflation back below the 2% level.

High inflation levels force the ECB to hike rates in an economic environment it previously cut rates.

In its annual report, the Bank for International Settlements (BIS) discusses the current policy dilemma of central bankers and concludes that although 'a deeper and more protracted global downturn' can be expected, inflationary forces do still support 'a global bias towards monetary tightening'. The strength and stickiness of these forces will largely depend on the 'behaviour of wages'.

Within the euro zone, the ECB has signalled its concern about the recent pick-up in the ECB negotiated wages indicator. In the first quarter of 2008, the annual growth rate of negotiated wages stood at 2.7% compared with an average of 2.2% in 2007, the strongest acceleration recorded by this indicator since the early 1990s. Combined with rising inflation rates and inflation expectations, this will keep the threat of a wage-price spiral alive, even though leading labour market indicators suggest that the labour market has turned in the euro zone.

Surging oil prices (red line) drive inflation expectations (black line) higher, despite the deteriorating growth outlook and the expected rate hike of the ECB.

The close relationship between oil prices and inflation/ inflation expectations (see graph) suggests that the question whether such a wage-price spiral will materialize in the euro zone does also largely depend on the policy response in the rest of the world. Indeed, the recent period indicates that the global economic picture is becoming increasingly important, as it is global demand and supply that determines the price of food and energy products. In this context, it's very remarkable that at a time the US economy barely grows and the UK and euro zone economy are slowing rapidly that food and energy prices are rising so strongly. Unless speculation is driving prices higher, these figures suggest that the growth performance of Asia has become a dominant force in the pricesetting of commodities.

Over the past month, several Asian countries, including Taiwan, India, Indonesia and the Philippines have raised rates to fight inflation, but overall policy is still too lax compared to the surge in inflation and the high growth levels. A further tightening of monetary policy in Asia can be expected and should slow growth, ease demand for commodities and as such temper the current surge in commodity prices and inflation. It remains however very hard to predict from what point the slowdown of the world economy will start to affect commodity prices and consequently the inflation outlook.

Regarding Thursday's ECB meeting, a rate hike is widely expected and although some have raised the risk that the ECB may still back away from the rate hike due to renewed strains in the financial sector, just like they did in August last year. This risk appears very remote in our view given the potential credibility loss for the ECB. Unless they would be aware of major further problems yet to emerge in the financial sector, rates seem set to rise.

Concluding, as long as there is no clear sign available that inflation has peaked in the euro zone, the threat of higher rates will remain a clear and present danger in the euro zone. This threat will keep yields under upward pressure for now. But as two more rate hikes following the July hike are already discounted, the upside has become more limited. The technical picture supports this view, as government yields failed to break decisively above last year highs over the past weeks. Therefore, a further consolidation of yields within the recent ranges between 4.40% and 4.80% in 2- year yields and 4.50% and 4.70% in 10-year yields is the most likely scenario over the coming month.

With regard to 2009, a sharp slowing of global economy along with receding global inflationary pressures is becoming increasingly likely and can still bring ECB rate cuts back on the table. However, for the moment this is a too distant prospect to drive the market.

German 2-year yields in sideways trading range

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.