Central Bank Watch: Market Attention Shifts to ECB - Finally Time to Hike?
After last week's highly-anticipated Federal Reserve rate decision, in which rates were expectedly left on hold, markets have shifted their attention to the upcoming European Central Bank rate decision on Thursday.
After remaining on hold since June of last year, markets are beginning to speculate over whether the ECB will in fact follow up with rate action following strong signals sent in recent weeks from bank president Jean-Claude Trichet, including a comment before the European Parliament's economic and monetary affairs committee last week that a rate hike was "possible".
European Central Bank
Current Rate: 4.00%
Next Rate Decision: July 3
Market Expectations: Markets are currently pricing in a 98% chance of a rate hike at the July 3 meeting. (EONIA implied rate)
All eyes will be on the European Central Bank on Thursday as markets nearly fully expect its monetary policy council to raise interest rates for the first time in a year to address high inflation in the euro zone.
The earliest inflation figures from the German states suggest that German HICP inflation might have risen from 3.1% to around 3.3% in June, which would take German HICP inflation back in line with its recent series-high.
"The increase appears to have been due entirely to rising energy prices, suggesting that core inflation remains subdued at around 1.2%. But with headline inflation in the euro-zone's largest economy at such a high rate, the ECB will draw only limited comfort from this," noted Jennifer McKeown of Capital Economics.
On the other side of the ECB's plate is disappointing recent activity news from France and Italy, says McKeown. June's fall in French consumer confidence to a new series low points to outright falls in spending, while Italian business confidence fell sharply in June, more than reversing May's rise, and remains consistent with negative annual industrial production growth, McKeown pointed out in a research note.
"In all then, the ECB will remain concerned about the inflation outlook for a while yet. But the further deterioration in the outlook for activity suggests that (the July 3) widely-expected rate hike will prove to be a one-off," she wrote.
Holger Schmieding of Bank of America also questioned whether the bank's expected rate hike will be a one-time deal or the beginning of a series of hikes.
"We do not expect Trichet to send a clear signal this time. While hawks can point to the surge in headline inflation to a record 4% and some increase in wage inflation to argue for further policy firming, the doves can point to mounting evidence that the euro zone is heading for a major economic slowdown anyway, with a no-longer negligible risk of a recession," he wrote. "As the ECB will probably not yet muster a near-consensus on the way forward, Trichet may simply repeat his recent double negative, namely to say that the ECB has not decided on a series of rate hikes while not ruling it out either."
Once again, there was plenty of ECB-speak on the topic of high inflation and the ongoing financial crisis.
Speaking in London on Friday, European Commissioner for Economic and Financial Affairs Joaquin Almunia said that further increases in oil and food prices "could not be ruled out" and that high inflation levels were expected to last longer than previously believed. Almunia also emphasized that while inflation levels are projected to eventually fall towards the end of 2008, the primary concern is ensuring that inflation does not become "entrenched."
Also on Friday, European Central Bank Governing Council member Miguel �ngel Fern�ndez Ord��ez told reporters in Rome, Italy on Friday that while a rate increase in July was possible, it was not a certainty. Ord��ez also emphasized that no signals were given regarding rate increases after the July 3 council meeting.
Speaking in Paris on Thursday, Bank of France Governor Christian Noyer warned banks to be wary of their exposure to hedge funds as the effects from the U.S. market crisis may not yet be over. Noyer acknowledged that French banks were "financially sound" and had "provided proof of their resilience in the face of the financial turmoil in 2007." However, he added that banks in France need to be vigilant against new risks that may emerge.
Speaking to the European Parliament's economic and monetary affairs committee on Wednesday, ECB President Trichet highlighted that upside price stability risks were increasing and reiterated that the ECB was in a state of heightened alertness. With inflation expected to remain at high levels for some time before abating in 2009, the ECB president also expressed concern over the strong wage growth seen in the euro zone and noted strong service sector price pressures.
"Against this background, it is imperative that all parties concerned contribute to avoiding the emergence of broadly-based second-round effects," Trichet said. "This is essential to secure that longer-term inflation expectations remain firmly anchored in line with price stability."
Following his speech, Trichet reiterated that a small rate increase in July was "possible" and that the central bank had not signalled a series of rate hikes. "Of course, we never pre-commit," Trichet said, adding that the ECB was credible due to that fact.
ECB Governing Council member Nout Wellink said that he saw no signs of inflation slowing, that the higher inflation rate was affecting consumption and that the ECB would do whatever is needed to prevent high inflation levels from lasting over the long run. "I see the emergence of higher inflation paired with lower growth, but the term stagflation is too strong," Wellink said before the Dutch Parliament on Wednesday. Wellink also said that it was too early to speculate on monetary policy in the second half of 2008 and that the ECB was keeping all options on the table.
Speaking in Paris, France on Wednesday, ECB Governing Council member Christian Noyer said that upside price risks were rising, that the ECB's vigilance was justified due to the high inflation levels and that price stability would have to be achieved through monetary policy.
"It's first and above all by stabilizing inflation expectations that monetary policy can efficiently contribute to economic growth,'' Noyer said. "What we want to do is ensure a solid anchoring of inflation expectations, that's the reason why we have signaled a state of alertness of the board of governors."
In an interview with Germany's Manager magazine, ECB Executive Board member Gertrude Tumpel-Gugerell said that the ECB was prepared to raise its main refinancing rate if needed to negate the record-high increases in commodity prices. "We're monitoring current developments with heightened alertness and we're ready, if necessary, to react by raising interest rates," Tumpel-Gugerell is quoted as saying.
In an interview with Reuters on last Tuesday, ECB Governing Council member Athanasios Orphanides said the latest Ifo and PMI data would not influence the ECB's monetary policy and that the markets are correct in expecting a rate hike in July. Orphanides emphasized that medium-term inflation expectations are being monitored closely and that more rate hikes should be expected if the inflation outlook deteriorates further.
Testifying to the Spanish Parliament last week, ECB Governing Council member Miguel �ngel Fern�ndez Ord��ez said the ECB is on "high alert" and emphasized that the risks to price stability have increased. Ord��ez also pointed to increasing risks of second-round inflation effects, increasing food and energy costs and the possibility of a global inflation spiral.
The ECB will release its rate decision at Thursday at 7:45 a.m. EDT.
U.S. Federal Reserve
Current Rate: 2.00%
Next Rate Decision: Aug. 5
Market Expectations: Fed funds futures traders have priced in a 24.4% chance of a hike at the Aug. 5 meeting.
As had been widely expected, the Federal Reserve decided to hold its key overnight lending rate at 2.00% last Wednesday, citing balanced concerns over slowing growth and rising inflation.
In the accompanying statement, the Fed said "overall economic activity continues to expand, partly reflecting some firming in household spending."
It also noted that inflation is expected to moderate later this year and next year. However, the Fed noted that "uncertainty about the inflation outlook remains high," and that the upside risks to inflation and inflation expectations "have increased." The Fed said labour markets have "softened further" and that financial markets "remain under considerable stress."
While the general tone of the statement was balanced between concern for slowing growth and rising inflation, some economists noted a tilt towards inflation concerns. TD Securities strategist Eric Lascelles said the Fed appears to be taking a hawkish tone to keep inflationary expectations down and the U.S. dollar up.
Paul Ashworth of Capital Economics noted that it's known the downside risks to growth have fallen while the upside risks to inflation have risen, but he said there was no indication whether that means the upside risks to inflation now outweigh the downside risks to growth. "If the Fed really was planning to hike at its next meeting in August then we would have expected it to switch to an explicit tightening bias this week, by noting that the upside risks to inflation are its predominant concern," he said.
However, on Friday, the Federal Reserve's preferred measure of inflation, the personal consumption expenditures (PCE) core deflator, advanced by 0.1% in May, below expectations and contributing to a year-over-year change of 2.1%, according to a report released from the Commerce Department. Markets had been expecting a 0.2% monthly gain. Annual core PCE remains one tenth of a percentage point above the Fed's target level of 2.0%.
In other Fed news, in the minutes released from a meeting of Fed Governors to approve Bear Stearns' acquisition by JPMorgan and the establishment of a lending facility to primary lenders on March 14 and 16, the Fed reaffirmed that the moves were "based on recent, rapidly changing developments."
"These developments demonstrated that there had been impairment of a broad range of financial markets in which primary dealers finance themselves. The available evidence also indicated that the dealers might have difficulty obtaining necessary financing for their operations from alternative sources."
Participating in the meeting were Fed Chairman Ben Bernanke, Vice Chairman Donald Kohn, and Fed Governors Kevin Warsh, Randall Kroszner and Frederic Mishkin.
On Thursday, at a monetary policy conference hosted by the European Central Bank, Fed Vice-Chairman Donald Kohn said the effects of the credit crunch are continuing to work themselves out. The central banker added that financial markets continue to be under stress from a failing housing sector in the United States and that it is too early to tell whether countries had decoupled from the U.S. Kohn also said the rise in goods and energy prices is confusing given slowing growth worldwide, and argued that some countries should focus on fighting inflation and restraining growth.
Also last week, speaking via satellite to a conference in Johannesburg, South Africa, former Fed Chairman Alan Greenspan said the financial market crisis will continue for some time, and could last well into 2009. The data implies the U.S. economy is on the brink of recession, said Greenspan, citing forecasts for very sluggish growth over the next 12 months. Nevertheless, the Fed rate cuts over the last several months will help avoid a recession, he added.
Bank of Canada
Current Rate: 3.00%
Next Rate Decision: July 15
Market Expectations: The OIS implied rate suggests markets are fully priced in for the BOC to hold rates at the July 15 meeting. Markets are pricing in a 6% chance of a 25 basis point hike at the September meeting.
The Bank of Canada's next rate decision is not for another two weeks, but there's growing speculation that Canadian interest rates may not be headed anywhere any time soon.
HSBC Canada market strategist Stewart Hall wrote in a client note this week that he believes any North American interest rate hike is unlikely until at least the second quarter of 2009. "It is "difficult for the market to embrace a story that envisions the (Bank of Canada) jumping the gun in front of the Fed and embarking upon a rate hike cycle in the absence of the same out of the Fed given the very fear of providing the f/x community a one-way trade on CAD," he wrote.
Once U.S. rates begin to move up, Hall wrote, "the Fed's rate escalation ladder can be expected to be quite long and steep in keeping with the timely and decisive injection of 325bps of stimulus since September." However, he said the lack of urgency in the Federal Open Market Committee's statement released last Wednesday when "suggests that the FOMC is some way away from even putting that ladder up against a wall."
Meanwhile, CIBC World Markets economist Avery Shenfield said that unlike the U.S. greenback, "the Canadian dollar won't show any disappointment if, as seems likely, the Bank of Canada does nothing with rates over the next several months."
The OIS market is pricing in nearly no chance of a rate hike at the July 15 meeting, a 6% chance of a hike by either the September of October meetings, and a 50% chance of a 25bp hike at the December meeting.
It has been a light week for Bank of Canada news, though governor Mark Carney argued that there might be some benefits to allowing greater monetary policy flexibility during the current period of turmoil while speaking Monday before the Bank for International Settlements in Lucerne, Switzerland.
"Constraints in the policy framework may have helped to gain credibility for the framework when it was new, but now that it is better understood, it is time to ask whether we can do better," he said. Nevertheless, Carney pointed out that a more flexible monetary policy must not endanger central bank credibility and unanchor inflation expectations. Consequently, during periods of a short-term shock to prices allowing inflation to rise above target could be appropriate.
Reserve Bank of Australia
Current Rate: 7.25%
Next Rate Decision: Aug. 5
Market Expectations: 16% chance of a 25bp hike (OIS Implied rate).
While the Reserve Bank of Australia caught no one by surprise when it left its cash target rate unchanged at 7.25% for July, it did draw attention by changing its policy language to focus more on growth and less about inflation.
In a statement released by bank governor Glenn Stevens following the rate decision, the bank said, "Indicators of household spending have recorded subdued outcomes over recent months, and credit expansion to both households and businesses has weakened significantly. There have also been some tentative signs of an easing in labour market conditions."
Joshua Williamson, senior strategist at TD Securities in Sydney, said the sentence adds some signs of downside labour market risk, such as income and employment growth risk, to the ongoing concerns about credit growth and "shows that the pendulum is swinging in favour of weakening economic conditions rather than lagged inflation."
He noted that while there were concerns about inflation from the jump in oil prices, they were tempered somewhat by the acknowledgement that rising fuel costs will work to also constrain demand.
"The statement was also telling for what was missing," Williamson noted. "Gone was the reference in the June Statement to 'Should demand not slow as expected, or should expectations of high ongoing inflation begin to affect wage and price setting, that outlook would need to be reviewed'. The removal of this previous concern shows that the RBA has enough evidence to feel more confident that economic activity will slow and with it inflation."
Bank of England
Current Rate: 5.00%
Next Rate Decision: July 10
Market Expectations: Markets are currently pricing in a 33% chance of a 25bp rate hike at the July 10 meeting. (SONIA implied rate)
Just like the situation the European Central Bank currently finds itself in, some economists say the Bank of England could soon find itself in a rate hike debate given high inflation and mixed economic data.
Following the release of PMI manufacturing for the UK Tuesday morning, Bank of America chief economist Holger Schmieding said while "excessive" inflation and mixed data on GDP and retail sales could still trigger a rate hike debate at the BOE, the sharp downturn in manufacturing now adding to the housing market blues, has made a rate hike less likely. "In addition, the Bank of England, presiding over the City of London, one of the top two financial centres of the world, will be likely to pay more attention to the recent drop in equity prices than other central banks," he wrote in a client note.
Last Thursday, while testifying before the UK Parliament, Bank of England Governor Mervyn King said he expects inflation to rise further this year and to possibly exceed 4%. He added that recent survey data indicates that UK economic growth will slow and that the economy is likely to weaken in 2008.
Also speaking to Parliament, BOE policy-maker John Gieve said he sees strong upside risks to wage growth, as well as price expectations, and echoed King's forecast of 4% inflation. Gieve also suggested that the current tightness in credit will remain for some time and that excess capacity in firms is expected to keep wage pressures down.
Bank of England's Paul Tucker reiterated that short-term inflation expectations had risen, but added that medium term expectations are still satisfactory. However, he emphasized that there is no room for complacency regarding expectations.
BOE's Kate Barker said a period of excess capacity for firms would help to keep inflation from becoming entrenched and that the interest rate path for 2008 is uncertain.
All members testifying admitted to having contemplated rate hikes at the last meeting.
Vicky Redwood of Capital Economics said the more interesting revelation of King's testimony was his comment about his open letter to the Chancellor sent the previous Tuesday. "The Governor said he was surprised by the dovish interpretation of the letter, which no doubt explains why he gave a more hawkish slant to his Mansion House speech the next day," Redwood said. "That said, the Governor didn't give the impression that a near-term rate rise is on the cards, emphasising that the letter was intended to be 'well-balanced' and expressing surprise at just how sharply interest rate expectations had turned around over the past month."
Bank of Japan
Current Rate: 0.50%
Next Rate Decision: July 15
Market Expectations: 92% chance of a hold, 8% chance of a 25bp hike (OIS Implied Rate).
It was a quiet week for the Bank of Japan, though BOJ monetary policy board member Seiji Nakamura said central bankers have to be flexible in implementing policy given rising uncertainties over the economic outlook, and that a predetermined monetary policy path was inappropriate.
Speaking to business executives in Asahikawa, Nakamura said it is important to monitor consumer inflation expectations and corporate price setting behaviour. He also said the U.S. economic slowdown is intensifying.
By Stephen Huebl and edited by Cristina Markham