Lost in Translation at the ECB?
As per usual I am coming in a bit behind the curve relative to my usual brothers in arms on ECB watching, Chaney/Bartsch from MS' GEF and Eurointelligence. Regarding the actual ECB meeting which was held this Thursday the refi rate was expectedly kept at 4.00% but the interesting thing of course, as ever, was the close attention towards Trichet's comments pointing forward to future monetary policy. So what did he say then? Well, this is the point ... I am really not sure something which is of course mirrored in the analyses linked above by MS and Eurointelligence. Regarding my own predictions I nudged them (reluctantly) up to 4.25% back in the beginning of June but I also recently noted, in a large data review, that the economic outlook was becoming increasingly blurred towards the latter half of 2007. However, with the recent strong PMI readings on manufacturing and particularly services demand I would have expected the ECB to come out much more aggressively hinting to a hike in September. This does not seem to have been the case although of course ECB-speak is not always easy to discern. From a strict economics point of view I think, however, that this is good news for the Eurozone since I quite simply don't think that the ECB should raise beyond 4.25% which still seems to be the lowest possible refi rate on which we are going to end 2007. However, I can also understand Bartsch' frustration (linked above) as a market participant with the recent ECB meeting since at this point it is difficult to see just what the ECB is going to do in the meetings to come. Another hike seems a safe bet but when and of course whether it comes sooner (September) or later (October) will also determine the outlook for more hikes in 2007 and thus positions in the FX market. Having said that, I still think that the official MS ECB forecast of 4.5% is too high and no matter when the ECB chooses to move I think 4.25% is the right call for 2007. On this I am in aggreement with Eurointelligence that if inflation pressures and steady monetary expansion prompted the ECB to move closer to 5% it would seriously cripple growth in the Eurozone where I think that future data will further point to a slowdown in momentum, especially from domestic demand indicators.
On a final note I want to emphasis some of the notes from Trichet's introductory statement. Of course, the main discourse remains anchored in the risks to price stability and especially liquidity conditions measured by the M3 continue to take up a lot of the ECB's attention. However, another discourse string which is emerging relates to, as also covered by Eurointelligence, the increasing pressure on prices from rising capacity utilization and essentially constraints. The following is a relevant quote ...
To sum up, in assessing price trends it is important to look beyond any short-term volatility in inflation rates. The relevant horizon for monetary policy is the medium term. Risks to the medium-term outlook for price stability remain on the upside, relating in particular to the domestic side. As capacity utilisation is high and labour markets continue to improve, constraints are emerging which could lead in particular to stronger than expected wage and profit margin developments. Given the vigorous monetary and credit growth in an environment of already ample liquidity, a cross-check of the outcome of the economic analysis with that of the monetary analysis supports the assessment that upside risks to price stability prevail over the medium to longer term.
From a traditional monetary policy perspective I have absolute no problem with this reasoning. However, the crucial question remains as to why capacity constraints are emerging and whether the drivers of this are structural or cyclical. The main question here is two-fold. Firstly, just how inflationary will decreasing capacity be? Clearly, inflation is seriously mounting in many CEE countries but what about in Germany and Italy? Secondly, even if the grind down of capacity is inflationary how should monetary policy respond? This question is directly related to whether in fact not the decline in capacity is deeply structural as a result of ageing and a surplus of exits over entrants in the labour market. Of course, the continuos process of high growth exacerbates this through cyclical effects. But, my main worry is that ECB could end up chasing its own shadow for all the wrong reasons in the fight against inflation and when at some point push comes to shove in key member countries they might end up finding themselves in a hole with slippery walls.
Thursday's ECB meeting left the markets wanting more as regards to future policy decisions from Frankfurt. Concerning an interest rate call I am staying put and with the increasingly blurred outlook for economic fundamentals and now also ECB decisions I think 4.25% is the right number for 2007. My guess is that it will come quick in September with the ECB then on hold for the remainder of 2007. As always, indicators for domestic demand as of course inflation pressures should be watched carefully. Especially, I think that the ECB will be sensitive towards the increasing decline in capacity but sadly as I argue above for all the wrong reasons.