Still Going Up in the Eurozone

As expectect the ECB raised the refi rate  (see also Q&A session) last Thursday from 3.5% to 3.75% and in essence it was very much business as usual in Frankfurt but as the end of the ECB's tightening cycle is moving closer the ECB's ever so clear and concise communication strategy is getting more and more murky. Or is it ... difficult to say really but there are indeed some differences between how commentators are dealing with the recent hike by the ECB and indeed how the central bank will move in the rest of 2007.

Referring first to yours truly I have a note up over at GEM where I present the recent data of the Eurozone as well as I am reviving my continuous rant against looking at the Eurozone as one homogenous economy. In terms of the actual interest rate decision and since I have been rather critical of the ECB's prolonged tightening cycle all in the name of the 'interest rate normalization' I think (and perhaps hope) that this was the last hike for now. However, this is far from certain so formally I am putting the chance for an additional rate hike in June at 60/40 in favor of a hike (yes I know, economic forecasting is so easy; it is the 'getting it right' which is difficult :)). Here is the intro from my piece ...

If there is one thing you can be sure of as an ECB watcher it is that Trichet and co. almost always delievers as expected, a virtue of credibility which of course is very dear to any central banker's heart. Consequently, the ECB today upped the main Eurozone interest rate 0.25 base points to 3.75%. The rate hike comes pretty much as expected but it also comes at time when markets seem a bit more jittery than usual on the back of rising probability of a recession in the US as well as the fact, and in the light of more recent data to be presented below, that the Eurozone's stellar performance in the 4th quarter is now little more than a glimmer in the rear-view mirror.

Over at Morgan Stanley the always sharp Elga Bartsch is more hawkish than I am and consequently she thinks it is quite certain that we are heading for another and perhaps a couple of hike(s). One of the notable ingredients of this call is the recent wage deal in the German chemical industry which came in a lot higher than observers expected. This of course is seen as a proxy for wage-push inflation and this will reinforce the ECB's reason to remain vigilant since we know very well that wage-push inflation, particularly in Germany, has been invoked before at the ECB as a prime inflation boogie man. Another interesting aspect about Elga's piece is the very peculiar nature of ECB watching and in particular the gauging and scrutinizing of the Q&A session. As such, it appears that this excercise takes more of a degree in semantics and de-coding than a degree of in economics or finance. Moving back on track here is the summary of Elga's piece ...

Such a settlement [i.e. the wage settlment noted above], which would be considerably higher than most observers including yours truly currently expect, would likely add to the inflation concerns of the ECB Council (EuroTower Insights: Whither Euroland Wages, October 20, 2006). In this case, reaching a refi rate of 4.25% before year-end would become more of a probability rather than just being a possibility. Currently, we are penciling in a 4.25% level for the refi rate for early 2008. But the risks of reaching that level earlier are rising right now.

Finally, we have Eurointelligence which also presents a slew of commentaries and references on the recent ECB decision and outlook on the economy. First off, we have Munchau's comment which notes how the ECB's tightening cycle quite possibly is about to come to an end. Munchau notes how the days where the ECB pushes forward the expectations of another rate hike by uttering the word 'vigilance' are over. As such it does indeed seem as if the ECB wants to hedge its bets going forward further into 2007. On the other hand of course the Q&A session still revealed the ECB's opinion that the monetary stance was still considering 'accomodative' so once again I guess that it is still about semtantics here and essentially also a lot about how the data from here on until June (i.e. Q1 and Q2) rolls in from the Eurozone and not least in the US as well. What follows is my clip,cut and paste version of Munchau's conclusion ...

'Is the ECB going to raise interest rates to 4%? We continue to think that there is a reasonable chance that this may happen. But please take note: if it happened, it would most likely happen in June. If it does not happen in June, the probability of a rate rise will fall with each month that passes (just as the probability of a rate cut to below 2% fell persistently during 2004). There are members in the ECB’s governing council who would clearly favour a rate increase to 4% as soon as possible. But we would be very surprised if there was anything even approximating a consensus on this subject today.

(...)

The Europeans have more reason to fear a slowdown in global growth, or an instability in global financial markets, than a rise in domestic inflation – especially since the exchange rate is more likely to strengthen than to weaken. So we expect today’s press conference to usher in a new on-the-fence period where policy could move either way.'

In terms of other sources from Eurointelligence notable attention should also be ascribed to this note which, despite the wage settlement in the chemical industry emphasised by Elga Bartsch above, argues that German labour costs will only barely rise in 2007 as a result of the expectations of fairly modest wage settlements in the public and service sector, the latter of course being of great importance since services by far account for the lion share of the German economy. Finally, Eurointelligence also presents a press review of the recent press coverage of the ECB decision as well as a note by juergen von Hagen from University of Bonn which questions the ECB decision in the light of the 2% inflation target.

In Summary

Given the commentaries and references cited above what is then the outlook for monetary policy in the Eurozone? Well, I maintain my 60/40 call in the light of my fundamental belief that the ECB will face continuously more difficulties in pressing on with rate hikes as the outlook in 2007 becomes clear. However, I take the point made by Elga Bartsch on the German wage rounds and the ECB's perception of this as future wage-push inflation. Another thing is of course the continuous buil-up of liquidity measured by the M3 which is also seen by the ECB as a future sign of inflation. The fact that I view these indicators in a different light than does the ECB and the fact that I think the data will reveal that the economic fundamentals of the Eurozone do not merit much more of this interest rate normalization process we cannot deny that ECB has its indicators firm in sight and as such might continue further than expected.