Growth and price dynamics in Europe are confirming early forecasts that Europe is expanding at a good pace. This picture is fully consistent with the strategy of gradual but steady tightening of monetary policy that the European Central Bank has followed so far. The question is now whether what has already been done is enough to guarantee price stability, while supporting a good level of economic activity. While we should have a better sense of the macroeconomic effects of the past tightening in the next few months, with the recent data on inflation and GDP growth, and in light of movements in oil prices, it seems that there is room for another step up in the near future.
There are signs that the peak in euro area economic activity is already behind us; the issue at stake seems to be how gradual the deceleration in the months to come is going to be. At the same time, though risks to inflation remain on the upside, the more adverse scenarios for the inflationary outlook have failed to materialize. As regards financial market developments, two new important elements need to be factored in. First, the strength of the euro, if sustained, may have a significant bearing on economic activity which should not be downplayed. And second, there have been a certain re-pricing of risks in financial markets which entail a “de facto” tightening of financing conditions. Under these circumstances, although I still favour a 25 bp increase in the refinancing rate in September, I think the ECB should subsequently remove its tightening bias and take a position of “wait and see”. This would give the ECB a greater margin of manoeuvre to assess and react to incoming events.
The real effective exchange rate of the euro against a basket of 44 currencies has not shown a significant appreciation since 2004. The real effective exchange rate against a smaller group of currencies (12 OECD currencies) has been appreciating but not very much. One possible conclusion could be that the recent appreciation of the euro against the dollar is benign. This is to forget the accumulated appreciation in real effective terms since 2001: +33% against a basket of 12 OECD currencies; +27% against a basket of 44 currencies. A standard model of behavioural equilibrium exchange rate shows that the euro is overvalued by around 10% in real effective terms. I am not sure that the ECB should encourage an over-shooting of the euro, which could potentially have strong delayed effects. If futher hike is needed (which may actually be the case), it would be wise not to do it precsisely when the euro is appreciating fastly against the dollar.
At present, it is not possible to tell with certainty whether ECB rates are still somewhat too low, or just right. Plausible estimates for the neutral rate span from 3.5 to 4 %. In a situation were neutrality has been reached, monetary policy decisions should be even more data-dependent than usual. As for the question whether to stop or to continue the tightening cycle, the three most crucial developments to monitor are:
1) Whether the past rate hikes (with their natural time lag) soon start to have more of an impact in curbing lending growth. The latter ceased to decline in the last few months in a break with the previous trend.
2) Whether the recent brisk investment activity is strong enough to prevent capacity utilization from rising further and generating upward price pressures.
3) Whether wage increases remain contained although the unemployment rate is currently at a historical low.
In my view, the recent data seem to give a positive answer to these questions. Therefore the ECB can consider the option of a longer pause than three months between its moves and reenter the tightening cycle later, if new information underpins the necessity.
The recent rise of the euro exchange rate does not really changes my assessment on interest rates: I still see the need for further rate hikes under the current economic environment. The area of the economy that requires to be cooled down is the credit to the private sector. So far the rise of the euro has no impact on this area. This argument is certainly not enough however to ignore the exchange rate environment while monitoring monetary policy. Volatility in Forex markets has increased significantly in recent weeks pushing the euro to record highs not only versus the dollar but also against the yen or the Swiss franc. More than the absolute level of the exchange rate, market nervousness is something a central bank needs to consider as a factor of risk that any change in monetary policy might exacerbate. While there is no need to rush to complete the normalisation of rates, this environment on the exchange rate front is risky enough to suggest keeping rates unchanged this month.
I see no need to speed up the pace of tightening. Looking further ahead, if the euro keeps appreciating, I might postpone voting for a 25bp increase.
The bilateral exchange rate of the euro vis-à-vis the US dollar is not a matter of great macroeconomic significance for the Eurozone. It is also becoming apparent that, while oil and many other globally traded commodities continue to be invoiced in dollars, their dollar prices are no more than the expression in US dollars of the relative prices of these commodities and some broad basket of core goods and services, a relative price that is determined, to a first order, independently of the value of the Eurozone’s nominal dollar exchange rate. So onwards, ever onwards with rates in the Eurozone. Another 25 bps in August, please.
Since last meeting, market developments imply a significant tightening of financial conditions, as long-term yields have risen and some corporate bond spreads have widened, while equity markets have been roughly flat. These trends reinforce the need to be cautious before rushing to hike short-term rates again without any obvoius need. Thus far, the recent appreciation of the (trade-weighted) euro has been relatively small, but its trend also suggests that financial conditions may tighten further through the exchange rate.
GDP growth appears to have moderated a bit again in the 2Q and, although the outlook remains favorable it may indicate that policy has tightened enough to slow the economy to its potential. Futhermore, the full effect of past tightening measures still has to feed through fully.
Higher oil prices are raising the near-term inflation profile, implying that it will exceed (probably temporarily) 2.00 pc. clearly late this year and through 1Q 08. However, core inflation remains well under control. In 2Q, goods inflation moderated again, and so did services (once the impact of the introduction of the university fees in some German states is excluded). All measures of wages remain well behaved. As a result, prospects for below-2 pc inflation for most of 2008 remain favorable, unless GDP growth stays or rebounds again above trend. This will only become apparent until after a few more months.
All in all, I would maintain rates unchanged with no bias in either direction.
As I elaborated at the last meeting, my outlook is for perhaps another rate increase in 4 or 5 months if the current robust growth is maintained. The recent appreciation of the euro and the tightening of financial conditions in credit markets are, at the margin, reducing the need for a further rate increase and/or lengthen the period over which it should happen. The recent tightening of credit conditions is a useful reminder that there are several lagged effects in the system that still have to feed through the economy, and the recent 200 bps increase in interest rates in the euro area still needs to be absorbed fully. Thus, the time is arriving of proceeding with caution, thus my proposal to lengthen the period in between rate increases.
The final national accounts data for Q1 2007 showed an upward revision to GDP growth to 2.85% q/q annualised (up from 2.4% previously) and for 2006 to 2.9% from 2.8%. This upward revision suggests that there is somewhat less slack in the economy than previously thought, a message that is confirmed by other measures of spare capacity. With survey data in Q2 consistent with ongoing robust growth it is now quite likely that growth this year will be almost as strong as last year, that is around 2.7% and well above potential. This suggests that rates should still be raised somewhat from their current levels. The upcoming release of the Q2 national account data will be an important reality check to that effect.
However, looking ahead, downside risks to growth have increased somewhat recently on the back of the increase in the oil price and interest rates (long term yields up about 50 bps since March) as well as the appreciation of the exchange rate. There are early indications that business confidence is starting to moderate suggesting that growth might return to trend towards the end of the year and in 2008. In that context, measures of slack should stabilise, preventing any significant pick up in underlying domestic inflationary pressures. Under this scenario, there does not seem to be a need to bring rates in restrictive territory. With inflation anticipated to small somewhat below 2% next year, a real rate between 2.25% and 2.50% seems appropriate.
The recent appreciation of the euro plus the tightening of credit conditions has already brought about some tightening in monetary conditions. For the moment no further tightening is required.