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Euroland The ECB in September and Beyond Euroland Stronger Growth, Higher Inflation, Higher Rates View GEF Archive

		The Global Economics Team

			Elga Bartsch
Elga Bartsch is an Executive Director whose main research focus is the monetary policy of the European Central Bank.
		Read about other GEF team members

In light of the upward revisions to our growth and inflation forecasts (see Euroland Economics: Stronger Growth, Higher Inflation, Higher Rates, June 7, 2007), we also raise our refi rate forecast for the end of this year to 4.5%, from 4.25% previously.  We are now looking for two more rate hikes in the remainder of this year — the most likely timing being September and December.  Once the 4.5% level of the refi rate is reached, which we would deem to be slightly restrictive, we expect the ECB to leave interest rates unchanged for most of 2008. In our view, the ECB will adopt a wait-and-see strategy to assess the lagged impact of its tightening campaign, hoping that the return to trend growth will help to dispel the mild inflationary pressures that have been building in the current buoyant upswing.  Initially, the ECB will likely maintain a tightening bias, which could cause the market to price in an additional rate hike in early 2008. Once it becomes clear that the ECB is pursuing a steady hands policy, the market might start to bet on refi rate reductions — a possibility that we wouldn’t rule out for late 2008 either. However, we would take a reversal in the ECB’s refi rate as a given. Due to its institutional set-up and its philosophy, the hurdle for a monetary policy U-turn is much higher for the ECB than for the Bank of England and the Federal Reserve, in our view.  If anything, the risks are tilting towards additional tightening to 4.75%, a level of the refi rate last seen in the boom of 2000.

All set for September?

As expected, the ECB raised interest rates by 25bp to 4% at its June Governing Council meeting. Having raised rates by a total of 200bp since December 2005, the ECB still views its policy to be “on the accommodative side”. While it no longer claims that euro area interest rates are moderate, it views financing conditions as favourable. Together with the Council’s view that the upside risks to price stability warrant “close monitoring”, this underlines that the ECB remains in tightening mode. By moving back to “monitoring closely” — a phrase last used in June 2006 — the ECB seems to signal that it will hike in September at the earliest. In the past 12 months, the ECB has always been “monitoring risks very closely” after a refi rate hike. Initially, this particular code has coincided with a slightly faster pace of tightening in the second half of last year. Since the beginning of this year, however, the ECB went back to its quarter-point-per-quarter routine. The ECB thus clearly remains in tightening mode. But by only “monitoring risks closely” it also seems to signal that it might move at a somewhat slower pace. In the past, it kept to its quarter-point-per-quarter pace when it started the new traffic light cycle with “monitoring closely”. While our ECB refi-meter model also points to a September rate hike, the signal is not as strong as it was, say, for the June meeting. Hence, a hike in September might not be a done deal yet.

ECB might still underestimate inflation risks

A notch below our own forecasts, the new ECB staff projections show upwardly revised GDP growth and HICP inflation forecasts for this year of 2.6% and 2.0%, respectively. The 2008 projections saw no change to the inflation number of 2% and a slight downward revision to growth, now at 2.3%. On the whole, the upward revisions over the full forecast horizon are slightly more muted than expected, and we would see upside risks to these projections. We would also highlight that the Governing Council, which does not underwrite the staff projections, sees upside risks to the staff’s inflation projections. In addition, we note that these projections are already a notch above its upper tolerance limit for inflation, which it aims to keep below but close to 2%. The upside risks to price stability, according to the ECB President, stem primarily from domestic sources, especially high capacity utilisation rates and favourable labour market developments.  As before, the ECB is concerned about strong money and credit growth against a backdrop of already ample liquidity. But it notes with some satisfaction the stabilisation of loan growth and house price inflation in reaction to its past rate hikes.

Looking for further bond market weakness

European government bond markets have seen a noticeable sell-off in recent weeks, led by marked rises in US Treasury yields. As a result, our year-end target of 4.5% for 10-year Bund yields has now almost been reached. Taking into account our upwardly revised ECB refi rate profile and our above-consensus growth and inflation forecasts for next year, we believe that the bear market isn’t over for government bonds yet. We now expect 10-year Bund yields to rise towards 5%, a level not seen since June 2002. While the first leg of the bond market sell-off was primarily driven by a re-rating of growth expectations, we believe that the second leg will likely be driven by rising inflation expectations.  If inflation concerns take hold not just in the bond market but also in the equity market, equities, which thus far have been somewhat sheltered by the re-rating of growth expectations, will likely struggle too. But it would probably be difficult for the bond market to break above 5% without a serious inflation scare. Once it becomes obvious that the ECB is going to stay put at 4.5% for a while, bond yields should start to ease again in early 2008, we think. And if the ECB indeed decides to lower the refi rate in late 2008, the bond market might be in for a round trip between now and the end of our forecasting horizon. On the whole, 2008 is likely to be a better year for bond investors than 2007, we think.

Euroland
Stronger Growth, Higher Inflation, Higher Rates
June 07, 2007

By Eric Chaney, Elga Bartsch, Thomas Gade, & Vladimir Pillonca | London

Boosting our 2007 GDP forecast

For the fourth time, we raise our euro area GDP growth forecast for 2007.  Building on the most recent cyclical indicators for the zone as a whole, as well as on our country expertise, we now see GDP growing by 2.7% this year, to be compared to 2.5% previously, and 1.9% in our December 2006 forecast.  More importantly, we believe that, for the first time since 2000, euro area economies may show signs of overheating next year.  We see wages accelerating significantly as the unemployment rate continues to fall toward levels not seen since the early 1980s, and we have raised our inflation forecast for 2008 from 1.9% to 2.2%.  Accordingly, we see the ECB’s refi rate peaking at 4.5%, rather than 4.25%, with the distribution of risks skewed to the upside.

When country analysis meets top-down estimates

Synthesizing the information embedded in the last round of large-scale business surveys, our Compass models concluded that production in euro area economies was currently accelerating (see Euroland Business Cycle Watch, Re-Accelerating, May 25, 2007).  Our early GDP indicator is well above trend, at 0.75% for 2Q (quarterly rate).  Now that we have more information on the dynamics of internal demand in large euro area economies, we believe that, indeed, a re-acceleration is likely in Germany, Italy and France, and we see only a modest deceleration in Spain.  Accordingly, we have revised our estimate for 2Q GDP growth to 0.7%Q, from 0.5%. Given that 1Q GDP growth was slightly above our estimate, it is not surprising that our full-year estimate rose to 2.7%, even though we believe that the next two quarters should be less buoyant than originally anticipated.  Note also that 2006 data were revised upward (to 2.9%), for the second time.  Future revisions are likely to go in the same direction, as statistical institutes take on board more comprehensive information coming from the supply side, especially from new companies. 

Landing close to trend speed in 2008

Going forward, the combined effects of tighter fiscal and monetary policies, as well as the strength of the euro, should have a more visible impact on internal demand.  Already, the most interest rate-sensitive sector, housing investment, is showing signs of weakness in countries where property prices went through the roof in recent years: Spain and France.  However, the impact of higher interest rates should be tempered by the recovery of the construction sector in Germany, where supply-side factors — including the elimination of excess capacity — are likely to have the upper hand.  In sharp contrast with 2001-05, Germany is now a factor of stability and growth in the euro area, and this should remain the case next year.  For that reason, and also because we do not expect another round of fiscal tightening next year (on the contrary, there is a risk that the French government will go for a rather aggressive fiscal expansion), we stick to our original 2.4% GDP growth call for 2008, which, on our estimates, is slightly above trend.  After three years of above-trend GDP growth, we believe that there will be little slack left in the economy next year.  Starting from the EU Commission estimate for the 2005 output gap (-1.3% of potential GDP), and assuming that trend GDP growth is 2.1% (the average over EMU years), we see a distinct possibility that the output gap becomes positive in 2008; in plain English, euro area economies could start overheating next year.

Raising our inflation forecast above 2% next year

Hence, we are raising our inflation forecast for 2008 to 2.2%, compared to 1.9% previously. In doing so, we have taken on board tighter labour markets fuelling wage increases, operating rates above the long-term average, and rising commodity prices, especially agricultural. We have not priced in a possible VAT hike in France, as we are waiting for further clarification on the French government’s fiscal strategy.  This factor aside, risks to our inflation forecasts now seem broadly balanced.

Watch unemployment falling …

Euro area labour markets have become tighter during recent years: the average unemployment rate dropped to 7.2% in April, marking the lowest rate in more than 20 years.  For years, unemployment has been trailing lower without causing a significant pick up in wage growth.  Global competition, starting with the extension of the European Union to central and eastern European countries and large migration inflows, have done their part in keeping a lid on wage inflation.  In addition, we believe that the improvement in labour markets is a sign that flexibility is improving in Old Europe, thanks to the growing share of flexi-jobs.  For these various reasons, it is plausible that the structural rate of unemployment has significantly declined over the last 10 years.

… and wages accelerating

However, there are now signs that wage growth is picking up, indicating that we might be close to or even below the structural rate of unemployment. We do not expect higher wage growth to be fully matched by productivity developments; therefore, we anticipate a rise in unit labour costs next year. Ultimately, higher input costs could be absorbed by profit margins in the corporate sector.  But even if this is the case in some highly competitive industries, we do not see it happening in general. High operating rates, not only in Europe but also in the global economy, should allow companies to protect, at least partially, their margins by raising prices.  On the price front, the conclusion is neat and clear: stars are aligning for a pick-up in inflation.

 

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