Euroland: Arguments for ECB to Hike in 2010
- The focus of the ECB now appears to be shifting from
whether to implement more stimulus measures to when to begin
- We believe that the euro area next summer
will have recovered so much that the ECB will consider interest rates
at historical lows as being inappropriate and will start hiking.
the ECB starts hiking it will probably deliver about 0.5 percentage
points each quarter, which was the average hiking speed seen in the
2000-01 hiking cycle.
- The exit strategy is likely to begin with alterations of the conditions for the long-term refinancing operations.
The focus of the ECB is shifting toward an exit strategy
On August 19, Governing Council member Axel Weber said to the German
newspaper Die Zeit that it is too early to withdraw stimulus measures.
We fully agree with that, but while some misinterpreted this as meaning
that more stimulation was needed we take note that the focus of the ECB
now appears to be shifting from whether to implement more stimulus
measures to when to begin withdrawing them.
Below we discuss in detail why we believe the ECB will find that the
conditions are in place to start hiking next summer and outline what an
exit strategy might look like.
Unless inflation is very high (as in July 2008) ECB policy tends to
be driven by growth developments. In 1999 the ECB started hiking when
PMI new orders were 59 and in 2005 it hiked when they reached 54. PMI
new orders are currently at 49.5 and increasing strongly. We anticipate
that they could reach 59, or more, in early 2010 and would thus send a
strong signal for the ECB to embark on a hiking cycle.
The ECB will have to revise its downbeat staff macroeconomic
projections significantly up at the next Governing Council meeting. The
ECB currently (June 2009) projects growth to remain negative until
mid-2010, but with France and Germany out of recession in Q2 this year
and the euro area in positive growth territory in Q3 - a year before
the ECB officially expects - it will clearly have to change its view
radically. We anticipate strong growth of about 3% q/q annualised in Q3
and Q4 09, driven primarily by the inventory cycle and exports.
Thereafter we expect that growth will slow down to around 2% q/q in
2010 and become more broad based.
At Jackson Hole on August 22, Governing Council member Ewald Nowotny
signalled a more positive attitude from the ECB when saying that "The
European economy will improve in the second half, driven by policy
measures, but a sustained recovery will likely not take hold until the
beginning of 2010". ECB president Jean-Claude Trichet also signalled a
more positive stance on growth, but also warned about the possibility
of a very bumpy road ahead. We will get the updated ECB staff
macroeconomic projections at the ECB Governing Council meeting on
The ECB assesses today's policy rate as appropriate on the basis of
existing information and analysis - i.e. in line with its extremely
downbeat forecast. It is unlikely that the ECB will keep this stance on
current policy rates for a prolonged period while at the same time
undertaking significant upward revisions to its growth projections.
Significant upward revisions in ECB's growth projections should also
result in upward revisions in its inflation expectations. Higher growth
would put upward pressure on commodity prices. It will also push core
inflation up, although this effect will be moderated by the negative
When the ECB is confident that the euro area is back on a
sustainable positive growth track it will be concerned that an interest
rate level of 1% is too accommodative. This is likely to be the case
when the labour market has stabilised, which we expect to happen in
early-2010. Trichet is already emphasising that the ECB is committed to
withdraw stimulus in a prompt and timely manner once the economic
outlook improves sufficiently.
The crisis has resulted in a large output gap, but this will not
pacify the ECB. ECB executive board member Jürgen Stark said on August
12 that "caution is warranted" concerning inflation projections made on
the basis of output gap estimates, since "such estimates are always
liable to major uncertainties".
Stark also said that "we have to realise that potential output has
gone down because of the deep recession". Indeed the European
Commission has published a paper (Occasional Papers No. 49/June 2009),
which concludes that the financial crisis has had a large negative
impact on potential output (and possibly potential growth) in the short
run. The output gap will thus be closed not only from below (because of
positive growth), but also from above, because potential output (and
possibly potential growth) has fallen. The ECB is well aware of this
and will take into account not only the significant uncertainty that
surrounds the size of the output gap, but also that the output gap is
likely to be smaller than simple projections of potential growth based
on historical performance would indicate.
We expect that euro area inflation will increase to 1.3% in 2010 and
will be around 1.5% in 2011. This is lower than ECB's inflation target
of "below, but close to 2% over the medium term" and from an inflation
point of view there is little need for the ECB to hike. However, after
a decade with a tendency for inflation to overshoot ECB's inflation
target they will be pleased to see inflation stabilising below their
target rather than above, so an expected inflation rate around 1.5% is
no hindrance for the ECB to start hiking. In addition the ECB considers
the risk of deflation as very small and diminishing, so this concern
should not keep the ECB from embarking on a hiking cycle. ECB board
member Stark said on August 12 that "we see the dangers of deflation as
very low... if there was ever a deflationary risk in the euro area,
then today that risk is much lower".
The ECB has also learnt the lesson not to keep rates "too low for
too long". The risk of fuelling new asset price bubbles by keeping the
refinancing rate at its historical low for too long is a strong
argument for starting the hiking cycle when sustainable growth has
returned even if inflation expectations remain subdued.
In his speech at Jackson Hole on August 22 Trichet took up "leaning
against the wind" as the first of three topical issues. Trichet argued
that it is possible for central banks to use monetary and credit
indicators to detect growing asset bubbles and then take steps to slow
rapid asset price rises. He also noted that "a strategy of leaning
against the wind could reduce moral hazard: by behaving more
symmetrically, a central bank can encourage more responsible behavior
on the part of investors and make a crisis less likely". Trichet is,
however, "doubtful that such a strategy can be implemented in a
mechanical way". Instead he suggests to use judgement that
"encapsulates the essence of leaning against the wind without
suggesting that central banks are in a position to manage closely -
much less target - developments in asset prices".
We would not be surprised to see the ECB lean against the wind during the next hiking cycle.
Annual broad money growth was 3.5% in June and is likely to decline
further before it begins to pick up early next year. The reference
value for M3 growth decided upon in 1998 is 4.5%. M3 growth has been
above this target almost ever since. In this respect the ECB is
certainly fine with money growth dropping to 3.5%, but it would not
like to see it drop much further. Money growth, however, is expected to
continue to decline - probably until the end of the year - before it
begins to pick up. Next summer the trend in M3 growth will again be up.
If the ECB extrapolate this pickup in M3 growth it could begin to fear
that monetary growth could soon move above their target again - and
almost certainly M3 growth developments will not give the ECB a reason
to remain inactive.
ECB is also focusing on the main counterparts of M3 in particular
annual growth in credit extended to the private sector, which has
fallen to just 1.5% in June. Annual growth in loans to the private
sector could turn negative before starting to increase again early next
year as demand picks up and lending standards begin to ease.
The ECB also studies the lending surveys in great detail. The July
lending survey showed that the number of banks that tightened credit
almost halved from Q1 to Q2. The credit tightening cycle is likely to
come to an end within a few quarters and as growth picks up and risk
aversion declines we are likely to see some banks starting to ease
credit in early 2010. This is another signal for the ECB that it can
start to normalise interest rates without jeopardising the economy.
The Bundesbank has stated in its August monthly bulletin that there
are "no signs of a general credit crunch in Germany". The ECB is likely
to agree with this view.
What will an ECB exit strategy look like?
The ECB has communicated that it has not decided on the sequencing
of the exit strategy. In particular the ECB will not necessarily
withdraw all non-standard measures before it starts to hike rates.
It is likely that a first step in an ECB exit strategy will be to
alter the conditions for the long-term refinancing operations (LTRO)
with guaranteed full allotment. The 12 month LTRO in late-September is
likely to be on the same conditions as the auction in June, but at the
12 month LTRO in mid-December we expect a spread to be included. This
is likely to be interpreted by the market as an indication that the ECB
expects to hike the refinancing rate within the next 12 months. As a
next step the ECB could decide not to continue with new 12-month
auctions in 2010 or it would decide no longer to have full allotment.
The EONIA overnight rate is currently below the refinancing rate.
Instead of hiking the refinancing rate the ECB may wish to close this
gap first by draining liquidity. Look for measures aimed to bring the
EONIA overnight rate closer to the refinancing rate. A move to variable
rate tenders from fixed rate tenders with full allotment is one
possibility (adding a spread at the 12 month LTRO will also help). A
normalisation of the spread could be a good signal that the next move
from the ECB is to start communicating a forthcoming hike in the
The signalling of the beginning of a hiking cycle could then take place in spring next year.
The exit strategy for the other non-standard measures will probably
not be implemented until end-2010 or later. The ECB already announced
in May that the temporary expansion of the list of eligible assets is
to be prolonged until the end of 2010. We expect that the collateral
pool will be narrowed thereafter, but this will probably not be
communicated before we are well into 2010.
The covered bond purchasing programme runs until end-June 2010.
After that we would expect the ECB to hold the EUR60bn portfolio until
2011 or later. The reduction of this portfolio could be one of the last
steps in the exit strategy.
When the ECB starts hiking it will probably deliver about 0.5
percentage points each quarter, which was the average hiking speed in
the 2000-01 hiking cycle and the maximum pace in the 2005-07 hiking
cycle. We expect PMI new orders to reach levels similar to those seen
during the first of these hiking cycles - possibly higher - and we
expect the ECB to react with a similar hiking speed.
Given that the refinancing rate comes from a historical low the ECB
has extra reason to favour a not too slow hiking speed. With a hiking
rate of 0.5 percentage points each quarter, the refinancing rate would
only have reached 2% at end-2010, which is still a very accommodative
level - and it would not reach a neutral level before end-2011. Given
that monetary policy has its maximum impact on a one- to two-year
horizon this scenario actually implies that monetary policy will have a
positive impact on the economy well into 2012.
The speed applied when monetary policy was relaxed in this
rate-cutting cycle was much higher. The ECB could aim to implement a
symmetric policy with rate hiking speed similar to the cutting speed.
Although we believe the ECB will try to "lean against the wind" and be
willing to hike despite low current inflation rates we do not believe
that the hiking rate will match the speed we saw in the cutting cycle.
The market currently prices around 25bp in June and around 60bp in September 2010.