Over the last month, uncertainty has not diminished.
Downward growth risks have increased. The tightening of financial conditions has continued and will stretch into the next quarter. The appreciation of the euro and the risks of hard landing in the US (and also in the UK, one of the main trading partners of the euro area) will add to these downward pressures. After the transitory growth pick-up expected for the third quarter, recent confidence indicators point to a deceleration in the following months. With respect to the inflation outlook, in the short run oil price increases could contribute to raise inflation somewhat above the expectations, although this should be only a transitory factor. However, in the medium term, demand pressures on inflation should moderate given the below potential growth projections for the coming months. Our inflation risk indicator (which measures the probability of inflation surpassing 2% in the medium to long term) points to a moderation after 1q08.
All in all, the Governing Council should not downplay the growing downward risks to growth despite the temporary rebound in inflation. The ECB should re-think its assessment of risks to the downside.
The dislocation in money markets continues and 3 month euribor at 4.6 is still equivalent to policy rates at around 4.5 percent, That has been in place since August and it appears is going to continue for a few more months. Clearly, European banks seem to still be in a very cautionary position, and lending is very likely to be curtailed, as the lending survey already hinted. With risks to growth clearly to the downside, inflation expectations very well anchor and the currency at record high levels, there is no reason why part of the recent tightening of financial conditions cannot be offset with a 25bp cut. The assumption should be that, should this rate cut prove to be a mistake, it should be reversed quickly. But were the downside risks to materialize, a rate cut once the economy has started to slow down significantly will arrive too late. From a risk management standpoint, a rate cut now seems to be the best course of action.
I think that the downside risks to growth have increased significantly in the recent past. These risks emanate from (1) a cooling of euro area real estate markets; (2) a tightening of credit conditions in the wake of the global credit crisis; (3) a disorderly appreciation of the euro. Against this, inflation risks seem to have remained stable. More generally, I think the ECB can only go against a pro-growth and possibly reflationary Fed policy at the price of a severely overshooting exchange rate that would cause recession. In global financial markets the Fed determines global monetary conditions and the ECB's monetary policy sovereignty is rather limited. Hence, should the Fed opt for further rate cuts (which seems fairly likely), I would expect that the ECB will have to follow.
The data on output growth and employment remain positive, pointing to a small correction relative to the outlook before the summer. For instance, while indicators such as the euro coin (or EUR-coin) kept falling in October, the overall correction is slight. Based on EUR-coin estimates, the underlying growth rate of the euro area economy has only lost 0.2 percentage points (from 0.84 to 0.64) since the beginning of 2007. Industrial production has been strengthening in the last month, and indicators of business sentiment remain cautiously positive in the short run: they do however appear to anticipate some cooling in the 2008. Consumer sentiment also keeps falling, although mildly. At the same time, the effects of the turmoil in the money market appear to be slowly disappearing. Clearly, what is left is a big question mark on the consequences of the summer financial shock for the real economy. The transmission mechanism is largely unknown as regards its quantitative impact. We know that interbank markets have not operated properly for a few months now. There are some signs of tightening of credit conditions, but some tightening was to be expected even in the absence of financial turmoil turmoil, per effect of the normalization of the price of risk at global level, already experienced at the beginning of the year.
The basic nature of the problem is apparent. First, global diversification of risk means that part of the US mortgage market crisis has translated into a wealth loss for Europeans. Second, the turmoil in the money market means that the direct effect of the wealth shock may be amplified by several times, as a run for liquidity has cut down credit and destroy wealth in a self-fulfilling manner. An assessment of these effects is difficult, if anything because of the well-known opacity in the valuation of mortgage-related assets. The behavior of monetary aggregates discussed by the European Central Bank can actually provide useful information to detect ongoing portfolio shifts towards toward liquid and safe assets. The evidence so far does not appear to be particularly worrisome, although it is well understood that uncertainty is quite high.
The benign growth outlook is largely conditional on sustained demand growth from emerging markets, which is supposed to offset at least in part the possibly mild US growth slowdown. The US slowdown need not be deep, especially because the Fed has been willing to tackle with output risks quite aggressively by cutting rates. As this translated into further dollar weakening, the lesson is that, even in the absence of a US recession, the net demand for European products from overseas will be quite weak and falling.
Inflation and inflation expectations have rebounded during the summer. In large part, this rebound has coincided with strong trends in energy and food prices, which is the inflation-side of solid growth in the emerging markets. In part it may reflect the expectations of an easier attitude on short-term inflation rates by central bank dealing with imported inflation at a time of financial turmoil. Inflation will be above target at the end of 2007, and the beginning of 2008. Rightly so, as short-run inflation dynamics is perfectly consistent with the policies efficiently pursuing the objective of price stability (it is optimal to accommodate part of price shocks in the short run), as long as expectations of inflation, and core-price and wages, are kept in line with the medium-run target. The evidence from the labor market is reassuring in this respect. However, arguably reflecting the considerable uncertainty on real variables, some measures of expected inflation has increased. Together with the data on growth, this evidence weight against cutting interest rates in Europe. Yet is should be stressed that the current level of the policy rate is not high: after all, the crisis caught the ECB just in the middle of a strategy of progressing tightening by small steps.
There is a growing number of signals that the real economy in the euro will slow down somewhat in the course of the next months, however not strongly enough, to justify a rate cut. Inflation is most likely to calm down next year. Under these circumstances an unchanged policy rate and no announcement of any bias appears to be for the time being the best monetary strategy.
Interbank money market rates have eased only marginally from last month, leaving 3-month rates significantly above what I deem to be a neutral level of 4%. The downside risks to growth have increased for three reasons. First, the US housing market looks even weaker than a month ago, suggesting that there is more downside to house prices and thus to consumer spending. Second, the euro has continued to strengthen. Third, despite the euro rally, oil prices denominated in euros have increased further. Taken together I think the risk of a hard landing for the economy in 2008 has risen further. Inflation is likley to rise further in the next several months, but longer-term inflation risks have eased a bit due to the weaker economic outlook and due to a more restrictive lending behaviour by euro area banks, which should slow credit growth substantially over the next several quarters.
Monetary policy has de facto tightened as credit conditions have become more delicate. Given the possible inflation pressure building up (high food prices, lower unemployment and high commodity prices), this is just what we would have needed. This is not the best way of tightening (prices work better than rationing) but, at last, there is no need for raising the interest rate. The only question is whether the tightening is excessive given the growth and employment outlook. I, for one, find it extremely to have a view. Bad news and good news pile up daily with no clear trend beyond the possibility of subdued growth over the next two quarters, i.e. over a horizon too short for monetary policy to make a difference. Given the volatility of signals, I believe that the only possible response is to wait and see.
The ECB's dilemma is that it cannot be sure how persistent the slowdown will be. If it is just transitory, that next year we bounce back, then easing now would risk stoking inflation pressures next year. But if it is the early stages of a major global slowdown, then easing at some stage will be necessary, especially if that entails a yet weaker dollar.
With the dollar's TWI down 10 pc y/y there is bound to be a substantial inflationary impulse from import prices, made worse by signs that China is now experiencing positive inflation for core consumer goods producer prices. The Fed is also facing difficult trade-offs, and has to embrace these within its dual mandate, but ultimately the ECB's well-understood mandate has resulted in much lower and more stable inflation expectations in the fixed income markets, which in turn has proved more supportive for the macroeconomy over the long term.
According to the hard data available thus far, economic growth in the euro area is likely to be more dynamic in the third quarter than in the second, with estimated sequential growth of 0.6 %. Nevertheless, the financial crisis has started to leave an evident mark on the sentiment indices and growth momentum will probably taper off somewhat in the winter half-year. Although the latest Bank Lending Survey indicates tougher lending standards, we only predict at most temporary reticence regarding consumption and investment among private households and businesses respectively, because current signs that turbulence on the financial markets is dying down are likely to gather force in the near future. That being said, the cocktail of unfavorable factors – especially the ongoing euro appreciation and oil price increase – is getting more and more worrisome for EMU growth perspectives.
Concerning inflation, the balance of risks has not changed in my view: higher growth risks reducing inflation potential counterbalance upward pressures coming from oil and food prices. Probably due to the increase in food prices perceived inflation in the European Commission’s consumer survey has risen in the last two months. However, there seems to be no serious threat for the anchoring of inflation expectations. Therefore the ECB should take a neutral stance in policy as well as in communication in order not to further support the € appreciation. In the current situation, the danger of the growth-dampening effect of the stronger currency is bigger than the benefit of its inflation-dampening effect.
Since the last meeting, there is clear evidence that banks are tightening lending standards significantly (quarterly Bank Lending Survey) and that business confidence is eroding (PMI, ifo.) Overall, these indications do not point to a major moderation of activity yet but the risks are clearly in that direction. Externally, the growth outlook in other industrial regions also is deteriorating, particularly in the U.S. (with an extended and major correction in housing), which should be partly offset by the continued dynamism of emerging markets. The latter seem to increasingly rely on domestic demand, implying a decent chance of a decoupling from the U.S. All in all, the outlook for euro-area growth in 2008 is around 2% (that is, at the lower end of the estimated range of potential) with the probability distribution schewed to the downside.
Upward price pressures are restricted to a relatively short list of items (such as some processed foods), and broader measures of inflation remain low. Core inflation ex-processed foods (roughly 70% of the headline HICP) is moderating again, for example, as a three-month calculation of the seasonally-adjusted series. Notably, service sector inflation is slowing quickly now on that basis. Area-wide wage growth remains stable, with a modest pick-up in Germany (much less than feared) offset by a slowdown in other countries up to 3Q. Finally, some leading indicators of inflation (import prices, price sub-components of PMI) indicate no upward pressures (rather the contrary), with rising oil and some other commodities offset by the appreciation of the euro. All in all, the upside risks to prices appear quite limited. There is a possibility that the price rises in “everyday items” leads to higher inflation expectations but the recent experience (euro changeover in 2002, rising oil prices in 2004-06
Daniel's comment goes to the heart of the current problem facing the ECB and other central banks in developed markets. The credit squeeze threatens economic growth. An undesirable tightening of financial market conditions would normally argue for lower official interest rates. Higher energy and food prices, however, threaten higher inflationary expectations and, hence, argue in favour of higher official interest rates. For the ECB, alongside the Fed and Bank of England, the obvious threat is a deterioration in the trade-off between growth and inflation. I'd argue that the root cause of this deterioration is the impact on global inflationary pressures of excessive demand in emerging markets, associated with overly loose emerging market monetary conditions. The ECB, and others, have to deal with the consequences of the willingness of emerging market policymakers to accommodate inflation and, unfortunately, that might imply lower than desirable rates of growth.
Over the last month risks to inflation and growth have both increased. Which one has increased by more is difficult to say because the uncertainty surrounding both has increased. One could argue perhaps that the uncertainty of the growth forecast has increased by more than that for inflation and that hence one should pay more attention to the risk to inflation. But the key consideration remains that the ECB is responsible only for price stability. The current outlook for inflation is for close to 2 %, hence there is no need to move rates, but one has to remain vigilant, given that inflation can be expected to stick to the upper end of the target.