Michael Hume (Chief European Economist, Lehman Brothers, London)
The ECB's July rate hike was primarily a precautionary move to counter the risk of rising inflation expectations. That decision was effectively taken in June and since then the dataflow has reduced the risk of any unanchoring considerably. First, break-even inflation rates over the policy relevant 18-month horizon have tumbled with the oil price. With the global economy weakening sharply the supply and demand outlook for oil looks consistent with further price falls rather than another price spike. Market expectations for inflation therefore look likely to be contained. Second, the euro-area economy has lost considerable momentum. I now expect two quarters of negative growth in the middle of the year and only a shallow recovery thereafter. Weak demand should, in time, have its own damping effect on inflation expectations. Finally, there is sufficient evidence to suggest that consumer inflation expectations are driven primarily by actual inflation. HICP inflation is now at, or very near, a peak. So consumer inflation expectations will almost certainly follow a downward path. The upside tail risk to inflation has diminished and the most likely scenario is that inflation will undershoot the ECB's definition of price stability over the medium term. The ECB should take the risk management policy approach to its logical conclusion and move quickly to reverse its precautionary rate hike.
Thomas Mayer (Co-Head of Economic Research, Deutsche Bank, London)
I The ECB's July 25bp rate hike was a mistake and should be reversed. Over the last twelve months the euro area has been hit by a housing market downturn as severe as that in the US, by a doubling of oil prices together with a surge in food prices, by a global economic slow-down, and last but not least by the most severe global financial crisis since WWII. As a result of these shocks private sector net saving is increasing and liquidity in important parts of the banking and financial sector is drying up. In this essentially deflationary environment, increases in inflation on the back of higher commodity prices are temporary and wage increases will lead to higher unemployment (rather than higher inflation). Nevertheless, monetary conditions have tightened in the equivalent of about 150 basis points (with about half coming from the exchange rate and the other half from Euribor-OIS spread widening plus the ECB hike). This combination is now pushing the economy into recession. Hence, a reversal of the monetary policy course is overdue.Supporters of the ECB's monetary policy tightening have argued that this is needed to contain rising inflation expectations, which would be validated by higher actual prices. However, this argument is valid only if we asume fully rational expectations. Only then would market- or survey-based inflation expectations provide an efficient forecast of actual inflation. But if we allow for the presence of bounded rationality and emotional factors (as we probably should--see the reaction of break-evens to oil prices) observed inflation expectations would be bad predictors of future actual inflation. More likely, inflation expectations would be influenced by recent past inflation (as agents use heuristics to make their forecast). A central bank chasing such expectations could make grave policy errors. In the event, it is up to the central bank itself to come up with an optimal forecast of future inflation and to use this as a guide for monetary policy.
Julian Callow (European Chief Economist, Barclays Capital, London)
Iit is important for central banks to ensure stability as far as is practical in their monetary policy. Therefore, interest rate changes of just 25bp should be made only as part of a trend change in the monetary cycle. As a consequence, I place a significant threshold on changes in the monetary policy interest rate. Back at the time of the (late) May Shadow Council meeting, I voted for an unchanged policy rate (of 4.0%) on the basis that the outlook for economic activity was deteriorating sufficiently to outweigh concerns at the time about rising inflationary pressures. Since then, it has become yet clearer that the euro area economy is certainly set to skirt recession, though I do not think we currently have sufficient evidence to predict a full-blown recession (which is a very rare event in the euro area). Still, it does seem likely that euro area unenmployment will gradually increase during the next two years.Even so, inflation expectations remain significant, and there is a formidable overhang of pent-up price pressure from commodity prices. Additionally, the euro's value has fallen about 2% on a trade-weighted basis since early August - this corresponds, roughly speaking and other things being equal, to about a 30bp policy rate reduction. We should note here that the euro's depreciation against the dollar (about 5%) has offset one-third of the 15% decline in oil prices, since early June. Above all, I would argue that, having juist raised the policy rate, I think that the ECB's credibility would be undermined if it suddenly were to lower the policy rate right now. My baseline is that the euro area economy will not enter into full-blown recession, given in part that the recent softening in the euro's value and in commodity prices will help to reverse the recent sharp downward movement in business confidence. That said, I recognise that the risks of recession have risen substantially, and that it looks increasingly likely that the ECB will need to ease its policy rate significantly during the next year.
Charles Wyplosz (Professor, Graduate Institute of International Studies, Geneva)
The latest news confirm what we expected all along: the slowdown wave is hitting the European shores. Given the mythical imprecision of these flash GDP estimates, it is very hard to say whether it is worse or better than expected, so I conclude that we are briefly on target. That suggests that there is no need to change the interest rate. Inflation too is developing as expected and, as far as I see, most forecasters see a peak these days. No need to change the interest rate here either. The reduction in oil prices and the dollar appreciation are the main surprises of the last weeks. That oil prices may be on the way down is a good news: less pressure on inflation and comforting for growth further down the road. It does not provide an argument to change the interest rate in any particular direction. The dollar revival is bad for growth in the Euro area, but since it signals a possible resumption of growth in the US, it is good for growth in the Euro area. Again, no signal for the interest rate.
Angel Ubide
(Cheif Economist, Tudor Investment Corp., Washington)
I did not vote for a rate hike back in June. Now, as growth has weakened significantly, it is tempting to say "I told you so", and call for a reversal of the rate hike. However, the situation is very unclear and cutting rates now may only generate confusion and volatility. The key question is whether the sudden weakness in euro area growth is mostly due to the lagged effect of the US slowdown and the credit crunch or whether it is the mostly due to the sharp increase in oil prices and the ECBs surprise interest rate hike. If the former, we may be witnessing the turn of the economic cycle and thus it will be appropriate to start thinking about an easing cycle. If the latter, as both oil and interest rate expectations have returned to where they were back in April-May, a rebound in confidence and thus growth outlook could ensue. The ECB argued that the surprise rate hike was intended to contain inflationary expectations. Despite the hike, and despite the decline in oil prices, inflation expectations remain high and one cannot see any appreciable improvement. In fact, 5yr5yr breakevens remain close to record highs and the Survey of Professional Forecasters has deteriorated. Thus, from this yardstick, if one was worried about inflation in the last few months the worry should persist. Overall, the ECB has to assess very carefully the incoming data. If growth is indeed weakening significantly despite the change in oil and interest rate expectations, a case could be made soon for the beginning of an easing cycle. If, however, growth stabilizes and inflation expectations remain as high as they are now, the ECB may have to back its words with further action. At this point, waiting and seeing with a clear neutral bias that leaves the door open for a quick reaction in any direction seems to be the best course of action.
Stephen King (Chief Economist, HSBC, London)
As one of the minority who voted for a rate hike last month, perhaps I have some defending to do. Growth has slowed - although the slowdown doesn't really come as much of a surprise - and oil prices have tumbled. But - and I think it's a big "but" at this stage - there can be no doubt that the trade-off between growth and inflation in the eurozone (alongside the experience of other developed economies) has deteriorated steadily over the last couple of years. The issue is not, then, that the eurozone economy is slowing down but, rather, whether the slowdown is enough to guarantee that inflation will become well-behaved again. Of course, the fall in oil prices has been helpful. I do not, though, believe that central banks - and shadow councils - should be in the business of chopping and changing on interest rates because of sudden movements in oil (and other commodity) prices. Otherwise, we'd have ended up in the ludicrous position of voting for rate increases in the first half of 2006, for rate cuts in the second half of that year followed by frantic votes in favour of higher interest rates through 2007. The fact is that inflation is well above target and well above the shadow council's own forecasts from a year or so ago. A vote for a rate cut now is a vote for a major loss of monetary credibility.
Marie Diron (Senior Economist, Oxford Economic Forecating, London)
It is too early for the ECB to reverse the July hike for two sets of reasons: credibility and the economy. And I do not think that the two reasons can be dissociated. Although I disagreed with the ECB’s decision to raise rates in July, if one was then in that frame of mind, the risk of inflation rising dangerously high has not diminished enough, even taking into account the now bleaker prospects for growth and the recent falls in oil prices. I have mentioned before the risk that core inflation remains high even as the economy slows down significantly. I think that this risk is still there and must have motivated the July hike. Central banks need to base rate change decisions on strong arguments and only significant events should make them abandon one set of arguments to switch to another.
Gernot Nerb
The majority of indicators clearly signal that the real economy in the euro area is in the midst of an economic downturn. There are also strong indications that we have passed the inflation peak. As soon as we get more information that the slowing of inflation is not only a temporary phenomenon but a longer lasting new trend, the ECB should start the easing cycle. I expect this point will be reached already in early autumn or at yearend at the latest.
Agnès Benassy-Quéré
Since the beginning of the summer, the economic situation has, in one sense, clarified. The economic slowdown has materialized in the euro area whereas commodity prices have fallen, reducing the fear of uncontrolled inflation. For sure, CPI is still forecasted above the ECB's target. But it now appears more clearly that inflation is not going to stay at an annual 4%. I think that the ECB should ease monetary conditions now. I understand the wait-and-see strategy, but the risk is that a rate cut come too late, when the economy resumes. There is also a risk of fiscal easing in the euro area, which would be less efficient than a rate cut as a policy reaction to the slowdown, since the latter is rather symmetric across euro members. Finally, I don't think reversing the recent hike would raise a big credibility concern. This is normal life under uncertainty. Failing to react to strong economic news is an equal threat to credibility. When each interest-rate movement is carefully explained based on available information, there is little risk for credibility.
