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07/04/2011

European Central Bank: In A Tightening Mood

Clemente De Lucia, BNP Paribas, Paris.

This article appeared in the June 2011 issue of Current Economics with permission of the author.

Key Concepts: Inflation | Monetary Policy |

Key Economies: Euro Zone |

The Tightening Cycle will Proceed…

At its June meeting the European Central Bank (ECB) Governing Council left its key policy rate unchanged, signalling, however, that an interest rate hike within one month was likely. The code word “strong vigilance” – which in the past had signalled a rate hike within one month – was included in the communiqué following the two-day meeting. It looks likely therefore that the refinancing (refi) rate will be raised to 1.5% in July.

The tightening cycle looks set to continue. President Trichet stressed that risks to price stability are on the upside. The ECB has revised upward its inflation projections for this year and left them almost unchanged for 2012. Admittedly inflation eased in May (to 2.7% from 2.8%, see Chart 1), but this looks unlikely to be anything more than a pause in a rising trend. After being distorted in April by the late timing of Easter, core inflation probably eased in May, but is also likely to start trending higher, albeit at a moderate pace, over the coming months. Firms continue to pass on past price increases in commodities to final prices. Alternative measures of underlying price pressures, such as the trimmed mean, which excludes the most and least volatile components from the harmonised index of consumer prices (HICP) each month and in the past has proved to be a good leading indicator of the traditional measures of core inflation, are on the rise. Lastly, ongoing growth in global activity – albeit at somewhat slower pace – will continue to keep oil prices at fairly high levels. Headline inflation will therefore rise over the coming months and could exceed 3% by year-end, before easing next year.

Other indicators confirm the build-up in price pressures. The output gap – the difference between current output and the level of production that can be achieved using available production factors without generating inflationary pressures, or potential output – is still negative, but it is closing, pointing to rising price pressures (Chart 2).

It is, however, worth noting that there are two reasons for the narrowing of the gap. First, it is true that the recovery in the eurozone has strengthened, particularly in the first quarter of the year. GDP growth accelerated to 0.8% (quarter-on-quarter) in Q1 2011 from 0.3% in the previous quarter, sustained by a sharp rebound in investment and by exports, while private consumption, constrained by still tough labour market conditions and the fiscal consolidation measures adopted in several eurozone countries, progressed at a much slower pace. The ECB has also revised upwards its growth forecasts for this year.

Secondly, however, it seems also likely that potential output has decreased as the disruption from the financial crisis has probably reduced the stock of capital and increased the structural rate of unemployment. The European Commission and the ECB are forecasting a potential GDP growth rate for the eurozone of between 1-1.2%, compared with close to 2% before the crisis.

Chart 1: Headline and Core
Inflation
Headline and core inflation
Chart 2: Underlying Measures of Price Pressures and the Output Gap
Underlying price pressures

...But at Moderate Pace

The picture for the eurozone as a whole masks deep differences between countries. Core countries, especially Germany, are doing pretty well. Activity in Germany has even come back to its pre-crisis level. However, conditions in peripheral countries are extremely different, with activity either showing very low growth or even contracting. Internal divergences within the zone are a problem for setting a common monetary policy and will remain so. The ECB will continue to set interest rates for the eurozone as a whole as it has done in the past. The Bank would place itself in a very difficult position if it were to be perceived to be setting interest rates with a view to economic conditions in a particular country or group of countries rather than for the region as a whole.

This said, internal divergences will probably affect at least two aspects of ECB monetary policy: the pace of monetary tightening and the exiting of non-conventional lending measures.

As regards the first point, it is likely that the ECB will continue to raise rates every three months, while in the previous tightening cycle, the Bank raised rates every two months (at least for a part of the cycle). An interest rate hike is likely to be more damaging for peripheral countries than for core countries. Spain and Portugal, for instance are among the countries with the most negative exposure to the ECB’s monetary tightening cycle, since almost all their mortgages have variable rates and are indexed to Euribor. As shown in Chart 3, disposable household income in Spain is much more sensitive to changes in Euribor interest rates than the eurozone average.


Chart 3: Relationship Between Disposable Income and Euribor
Relationship between disposable income and Euribor
Chart 4: Yields on 2 Year Government Bonds and the Refi
Euro yields

Although Tensions in Sovereign Debt Markets Persist, the Securities and Market Program (SMP) has Probably Ended

The interest rate monetary transmission channel is not working properly at present. Under normal conditions, monetary interest rate changes are transmitted along the yield curve, affecting the financing costs of firms and households. Higher policy rates would lead to higher government and corporate bond yields and to higher mortgage rates and interest rates. Prior to the financial crisis there was fairly strong correlation between all countries’ 2-year rates (where credit risks do not play a crucial role), and the policy rate. As shown in Chart 4, the correlation between yields on 2-year German and French government bonds and the refi rate remains strong. However, this is no longer true for those countries more affected by the sovereign debt crisis (see Chart 5). Funding costs for these economies are therefore much higher, as markets are extremely nervous regarding their fiscal positions. Conditions are also tougher for Italy and Spain (see again Chart 4).

In May 2010, when tensions in the sovereign debt markets intensified and the ECB launched its Securities and Market Program (SMP), interest rates on sovereign debt issues were below current levels. This would suggest that the SMP should be further increased. However, the ECB has de facto stopped the program at around €75bn. The last time that the Bank intervened in the market was at the end of March 2011. In this way the ECB is increasing pressure on governments to find a solution to the debt crisis by sending a clear message that they cannot count on the ECB to solve fiscal issues, something that could damage its credibility and independence. To some extent this is bearing fruit. EU leaders are coming closer to an agreement regarding additional funding for Greece, which will help to cover its funding needs until mid-2014. Given that there are divisions at the ECB Governing Council as regards the SMP, it is extremely unlikely that it will be expanded further.


Chart 5: Yields on 2 Year Government Bonds and the Refi
Euro yields
Chart 6: Banking Lending Rates (to NFCs Up to 1 Year) and Refi Rate
Bank lending rates

Further Withdrawal of Non-Standard Lending Measures has been Postponed

The ECB will continue to support the peripheral economies through its non-standard lending measures. At its June meeting the Bank decided to continue to conduct all its refinancing operations with full allotment at least until the end of September. The ECB is currently allotting more than 60% of its liquidity to Greece, Portugal, Spain and Ireland, whereas these economies amount to only 16% of the eurozone GDP. Portuguese, Greek, Irish and to a lesser extent Spanish, banks are still highly addicted to ECB liquidity, which suggests that they have problems in finding liquidity in the money market. Funding difficulties for the banking sectors are transmitted to the rest of the economy to some degree. Chart 6 shows the bank lending interest rates to non-financial corporations (NFCs – up to 1 year and up to €1 million) for some peripheral countries and for the eurozone as a whole. The common picture is that bank lending rates did not decline as much as the fall of the refi rate would have suggested (this was one reason why the ECB adopted non-standard lending measures during the crisis). Bank lending rates for the eurozone started to increase only moderately after the ECB announced in March 2011 that it intended to raise rates. However, this was not the case in peripheral countries where banking rates began to increase earlier and at a faster pace (again see Chart 6), meaning that funding costs for these economies rose faster than the policy rate would have suggested.

Chart 7: Euro zone-US 2 Years Yield Spread and Exchange Rates

Euro zone spread and exchange rate

All in all, the ECB will continue its tightening cycle. Inflation is on the rise and the Bank will use its standard policy instruments (that are key rates), to maintain inflation in line with its objective of price stability in the medium term. In addition, the Council fears that leaving interest rates at low levels for too long could create financial distortions, favouring further imbalances. Nevertheless, the ECB decided to keep its non-standard lending measures in place, as some segments of the money market are not working perfectly. The ECB is also the guarantor of the smooth functioning of payment systems as stated in the Treaty (art. 105), and, as Mr Trichet has said more than once, “whatever the interest rate, the money market has to function”. An unbalanced recovery and persistent tensions in financial markets will induce the ECB to proceed in its tightening cycle at a modest pace. Apart from anything else, the strong euro has the effect of tightening monetary and financial conditions, reducing the need for higher rates. Different monetary policy orientations on both sides of the Atlantic are widening the yield spread between the US and the eurozone, strengthening the euro (see Chart 7). The euro is likely to remain at elevated levels for a while (the OECD estimate of fair value is around 1.25, based on PPP for GDP), before easing next year when the US Federal Reserve is expected to start its own tightening cycle.


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