Looking Beyond June?

Well well, there has certainly been much talk around blogland recently about whether the ECB will raise beyond what clearly looks as a safe bet on a hike ot 4% come June. Over at Morgan Stanley's GEF the ever sharp Elga Bartsch sums up the recent views on the ECB's policy decision and outlook on the Eurozone economy and as she points out there are some (including of course yours truly) who do not see the ECB moving beyond 4% in June or perhaps (dare I say it :)) not even hiking at all? Here is Elga ...

Some observers argue that the ECB will soon find its tightening campaign being brought to a halt by a rapid deterioration in the incoming activity data. Others highlight that a further rise in the euro will rein in the hawks on the Council. This past week, even a nose-diving Spanish economy was cited as a reason for the ECB not to hike beyond 4%. Of these arguments, the potential repercussions of a rallying euro on the ECB’s monetary policy deliberations is the most convincing one, I think. Nonetheless, I believe that we should bear in mind a number of factors that will likely limit the ECB concerns about the euro’s ascent.

At the heart of the matter is of course the Euro and its recent perky mood vis-à-vis the Dollar and the Yen for that matter although Elga also notes that some see the risk of the real side of the economy (i.e. activity data) perhaps prompting the ECB to stop sooner than later. In terms of the MS GEF team I should also note Eric Chaney's recent contributions which are also much worth a look. As regards to Elga I have to say that although I do not see the ECB in any kind of vigorous tightening mode come June she makes a compelling case for why we should perhaps expect the ECB not to pay so much attention to an appreciating Euro. In general there seems (with emphasis on seems) to be a consensus amongst Chaney and Bartsch that the whatever effects rising interest rates and an appreciating currency will have on the real side of the economy will take some time to materialize itself which is quite natural given the nature of lagged economic effects in general. In terms of an impact on the export sector the lag is set to between 6-9 months; I guess those letter of credits are hedged through currency futures after all :)? Now, the traditional view here would of course go something along the line of pointing out that since an appreciating currency is deflationary in nature the perky Euro should actually do a part of the ECB's job without it having to correct the valves of the economy through monetary policy. But of course if Elga is right and that the transmission mechanism (pass through effect) of an appreciating currency into imports prices are less marked today it might make sense for the ECB to focus on those future wage pressures (push inflation) and monetary aggregate indicators (M3) after all? I am not sure I agree and in any case we should actually be looking at the assymmetrical pressured levied by the Euro on the after all different Eurozone economies ... so my advice, watch Italy! More generally, the Euro does indeed seem to be driven exceedingly more by the expectations on closing interest differentials between the Fed and the ECB and here I just do not see how the fundamentals will allow this to happen in any sustainable degree which agains means that the idea of de-coupling might hold in Q1 and Q2 2007 but that de-coupling in a longer term and with a more structural perspective implies an unrealistic belief as to how much the ECB can go north in an environment where the Fed has to hold.

Turning to other sources which have dealt with this recently include Sebastian Dullien from Eurozone Watch who argues not to be complacent on the back of the appreciating Euro. Also Munchau from Eurointelligence picks up this baton and invokes the idea that the ECB will risk overshooting the Euro exchange rate by going to much north. Finally, let us have a look at the recent data coming out of the Eurozone. We have of course Spain which seems to be wobbling somewhat at the moment, and Italy where consumer confidence slumped recently. And now it also seems as if the German consumer might be turning down the engine just a bit as we saw retail sales fall in March after a pickup in February. The VAT is identified as the culprit. In terms of consumer and business confidence in Europe in general the otherwise positive sentiment stalled in April although of course it is still at an all time high.

In Summary

I think it is fairly certain that the ECB will take it to 4% come June so all those long bets on the Eur/USD are safe for now I think but perhaps investors will soon be nudging it down to a neutral position which also of course depends on the incoming data and thus Fed outlook in the US. Moving on to the more normative side of all this I really do believe that the ECB would be best off not to raise in June. I base this on my prediction that we will see the data coming in pointing towards a more moderate pace of consumer spending and capex. As regards to the appreciation of the Euro which is of course all the rage at the moment it is I believe mainly driven by interest rate differential expectations (no reserve diversification yet) and not changing economic fundamentals as such so do expect some volality on the downside if future data releases on the Eurozone do not come out as bullish as expected as well as of course positive data on the US economy will have the same effect.