ECB picks its code words with caution

THE ECB surprised financial markets for the second time in as many months last week.

Having signalled its intent to raise interest rates two months ago, last week’s meeting brought somewhat better news in that the ECB refrained from doing something similar this time around.

In April the ECB used the phrase “monitor very closely” to describe its prevailing posture — language historically followed by a rate hike in two months time.

Such guidance four weeks ago left us (and indeed most ECB-watchers) expecting Trichet to use the phrase “strong vigilance” at last week’s May meeting.

However, the ECB instead retained the “monitor very closely” language, which suggests that a June move is much less likely than first thought. Indeed, we know from past experience that the phrase has less predictive power than “strong vigilance”, as the ECB’s Governing Council can maintain this stance for an extended period (as it did between September 2007 to June 2008).

To an outside observer, such phraseology might sound like verbal gymnastics. However, the ECB is fully aware of the importance and influence of its self-chosen code words.

The “strong vigilance” language has a fully understood purpose: to signal an imminent rate hike.

It has consistently served that purpose in previous hiking episodes. It was employed in March to signal the move which followed in April, and it was expected to make another appearance last Thursday.

So it would seem that the ECB has had some slight change in thinking, causing it to perhaps push out the next move in rates.

Somewhat unsatisfactorily, it is not fully clear why the ECB seems to be a bit less gung-ho on the idea of a June hike. One thing we can say is that it seems unlikely to have been driven by incoming inflation numbers out of the eurozone, as the April estimate was higher than expected at 2.8%. That took inflation further away from the ECB’s target of “close to but below 2”.

Perhaps the renewed deterioration in sovereign debt markets gave Council members cause to pause. Government bond spreads have hit fresh record highs in Greece, Ireland and Portugal in the past few weeks as market expectations about some form of restructuring of Greek debt have intensified.

Currency developments over the last month may also have contributed, with the Eur/USD rate moving from $1.43 to over $1.49 by the middle of last week — a higher euro helping to dampen imported price pressures, of course.

However, we didn’t receive a lot of colour on either of these points, with Trichet shutting down questions on Greek restructuring with a dismissive “not on the cards” response, while, as usual, not directly responding to questions on exchange rate movements.

The apparent softening of the ECB’s stance will be welcomed by Irish borrowers who could do without the additional strain of another near-term rate hike.

Exporters also received a boost from the news, as the euro fell back against both the dollar and sterling as the support from the prospect of higher interest rates receded somewhat.

However, it would be wrong for either borrowers or exporters to take too much comfort from Trichet’s comments.

In an interview on Friday, he introduced a new phrase into the ECB’s convoluted lexicon of code words: “extremely alert”, which may be an attempt to convey the idea that it has far from abandoned the idea of another rate increase in the months ahead. He also pointed to new ECB economic forecasts in June, which will almost definitely include a further upward revision to inflation projections for this year and next.

Overall, while it was a surprise that Trichet didn’t go as far as using the dreaded “V” word last week, it is probably only a matter of time before the ECB pulls the trigger on rates again.

Simon Barry is chief economist Republic of Ireland with Ulster Bank


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