29 August 2005

EZA 697: Briefing Note

ECB 1 September Council Preview
SLIGHT FURTHER TILT TOWARDS INFLATION CONCERNS BUT NO SHIFT IN ECB's POLICY STANCE OF 'CONTINUED VIGILANCE' EXPECTED UNTIL 2006 Expect no rate change at 1 September ECB meeting; EZA still sees rates likely to remain on hold until 2006 Q2, when 1 or 2 hikes of 25 bp likely. Tentative signs of activity strengthening in mid-2005, in line with ECB expectations; domestic cost and price pressures still largely contained. 'Headline' inflation rises to 2.2% but 'core' inflation remains very subdued. Possible hint of rise in inflation expectations and continuing acceleration of money/liquidity/credit growth together tilt balance of argument a little further towards risks to price stability if demand strengthens. Futures market still underestimating ECB's inflation concern and mis-pricing likely timing and scale of ECB tightening in 2006.

SummaryTaking the latest macroeconomic and monetary pictures together, we still see no early shift in the Governing Council's wait-and-see policy stance of 'continued vigilance', although the balance of argument has continued to tilt slightly further towards the upside risks to inflation, if stronger growth materialises, away from the (still present) downside risks to growth. EZA therefore continues to hold that the Governing Council is most likely - subject to the usual provisos concerning the risks posed by energy price developments - to keep interest rates at present levels through 2006 Q1. Then, on the back of accumulating evidence that domestic demand was strengthen ing, we would expect it to take the opportunity to raise rates by 25 basis points once, or even twice, in the course of Q2. This would bring nominal short-term rates back towards more normal historical levels and, with inflation subsiding, create a monetary tightening in real terms that would help to rein back the excessive growth of liquidity. This view did not appear to be widely shared in financial markets in the run up to the Governing Council's July meeting. Indeed the Euribor futures market at the end of June was factoring in a significant possibility of a rate cut towards the end of 2005. Since then, however, market sentiment has swung back a little in our direction, with the futures market now pricing in some likelihood of rate hike around mid-2006 but not a full a 25 point rise until September 2006. We continue to believe that this underestimates the extent of the ECB's concern about the potential threats to price stability from possible second-round commodity price impacts on wage- and price-setting and from the mounting liquidity overhang.

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© Graham Bishop