ECB unlikely to raise interest rates until March
Rates have been raised from 2% in late 2005 to 3.5% by December last, in what has been described as a process of normalising the level of official interest rates in the eurozone.
Based on recent comments from numerous ECB officials, it is clear that rates have not yet peaked in the eurozone. The ECB still regards monetary policy as accommodative and speeches by ECB officials have consistently highlighted the fact that the level of official rates remains low.
Meanwhile, the economy is growing at a strong rate. Although the ECB expects GDP growth to moderate towards its trend rate, ECB officials seem increasingly confident that 2007 will prove to be another year of robust growth for the eurozone economy, following the 2.7% rise in GDP in 2006.
The ECB expects inflation to hover around 2% in the next two years but, crucially, it believes the risks to inflation are on the upside. It notes the risks of a stronger pass-through effect on inflation of previous oil price increases and the possibility of a renewed rise in oil prices. Indeed, oil prices have jumped sharply again over the past fortnight.
More fundamentally, wage dynamics could be stronger than currently expected given the strength of economic activity and recent positive labour market developments.
The jobless rate has fallen to 7.5% in the eurozone, with a particularly sharp fall in German unemployment in recent months. Axel Weber, head of the German Bundesbank, has warned that high wage settlements are now the biggest risk to inflation.
ECB officials also believe the continued strong growth rate of monetary and credit aggregates poses another upside risk to price stability.
Eurozone M3 money supply rose at a record rate of 9.7% year-on-year in December, confirming that there is abundant liquidity in the economy, warranting a further tightening of monetary policy.
However, the ECB appears to have changed the timing of interest rate increases back to three-month intervals from two months. The ECB president did not use the phrase “strong vigilance” in describing the ECB’s concerns about inflation at last month’s press conference, suggesting that a rate hike in February is unlikely. Instead, Mr Trichet said all developments had to be monitored very closely.
This suggests that the next rate hike won’t occur until March. While commentators were somewhat surprised that the ECB did not signal the need for a rate hike in February, the president did indicate the market was correct in anticipating another increase in March. The market will be looking for further hints on Thursday that rates will indeed be increased in March. Any reference to a need for “vigilance” on inflation risks would be a strong signal in this regard.
Even after a further increase in March, it is likely that the ECB will still see policy as accommodative.
If the economy continues to perform well, the ECB will undoubtedly see a need to move to a more neutral stance. A further increase in rates to 4%, therefore, could well be on the cards by the middle of the year.
Where rates could go after that depends on the outlook for growth and inflation in the eurozone. Inflation should ease over the course of the year.
However, if euro area growth prospects remain strong heading into 2008, the ECB may see the need to move to a more restrictive stance. As a result, the 4% level may not represent the peak of eurozone interest rates.
Oliver Mangan Chief Bond Economist AIB Global Treasury
