Date: June 29, 2005 14:00GMT
Expert: Piet Lammens, KBC Head of research
Topics:
- Why does the Riksbank decision impact thinking on ECB policy?
- Are there still clear indications in the Euro area of a weaker outcome than was anticipated?
- Are lower interest rates warranted?
Who is Piet Lammens?
Piet Lammens Born in Louvain, Belgium on February 28 1958. Law degree, Catholic University of Louvain, Belgium Legal advisor 1982-1989.CERA: Economist Research Department 1989-97. CERA Investment Bank Analyst dealing room 1998.KBC Head of Research dealing room 1998
Speech Material:
- Swedish Riksbank cuts rates by 50 basis points to 1.5 per cent
- Statement cites weakness of Eurozone activity as a key factor behind the rate reduction
- BoE Minutes show a shift in sentiment towards an easier stance
- ECB is apparently split on the wisdom of a further cut
- Upcoming confidence measures will likely be important for ECB rate outlook
There have been a couple of significant developments in relation to Euro area interest rates prospects in the past couple of days, like the Swedish Riksbank decision to cut its rates drastically, a Reuters story on a split of opinion in the ECB regarding a rate cut and the Minutes of the June BoE meeting, showing two members voting for a rate cut, whereas in May one member still voted for a rate hike.
The rate cut by the Riksbank had been flagged well in advance by comments from senior Riksbank officials and so wasn’t a complete surprise. However, the boldness of the move, a 50 basis point rate cut and the motivation for the move were clearly not fully anticipated and resulted in a further decline in market rates.
Why does the Riksbank decision impact thinking on ECB policy?
The performance of the Swedish economy has been quite similar to that of the Eurozone in recent years (cf. graph 2) and as a consequence Swedish official rates have followed a similar, if not identical pattern (graph 1).
Nevertheless, some differences need to be highlighted, because of their importance in the EMU rate debate. The Swedish economy made more progress on structural reforms. This resulted in a somewhat stronger growth in recent years than the euro average, but also in much lower inflation. Whereas EMU inflation hovers currently around 2% year-on-year, the Swedish inflation is substantially lower and flirts with deflation.
However, despite the differences, the market immediately seized that the EMU case has similarities with the Swedish one.
Tellingly, the Riksbank statement today noted ‘GDP growth slackened more than anticipated at the beginning of the year in both Sweden and the Euro area’. The Riksbank statement went on to suggest that while softer growth in the US may be temporary ‘there are still clear indications in the Euro area of a weaker outcome than was anticipated’. It also indicated that while Monetary policy is ‘now considered to be well balanced,’ ‘ the future direction for monetary policy will depend on new information on economic developments in Sweden and abroad’. So, a further rate cut can’t be entirely ruled out in the Autumn, even if the market currently doesn’t discount an additional rate cut. Most importantly, the Swedish decision underscores the lack of momentum in the European economy.
The Minutes of the June meeting of the BOE brought also a small surprise. Indeed, during the May meeting, the MPC decided 8-to-1 to keep rates unchanged with Andrew Large voting for a rate hike. During the June meeting, the decision for unchanged rates was taken by a 7-to-2 majority, but the two dissenters, Mr. Bean and Ms. Bell voted for a rate cut. Mr. Large now voted for an unchanged decision. While the bias of the two dissenters is crystal clear, the Minutes said that those voting for an unchanged stance felt: “there was time to gather further evidence on the depth and extent of the slowdown in consumption to see if lower interest rates were warranted.” This seems to us a clear hint that sentiment is indeed tilting inside the MPC Committee towards lower rates. To trigger an effective rate cut, the data should point to weaker consumption growth. While this shift was mostly based on arguments about the domestic situation, there were some references to weakness in the euro area.
A Reuters report, based on unnamed sources inside the ECB, suggested the ECB Governing Council is split on the merits of a further Eurozone rate cut. The split reflects a number of considerations. First of all, there are differences of opinion as to the likely impact of a rate cut on the Eurozone economy. In this regard, the Bundesbank report noted that German households paid back more than they borrowed last year in spite of historically low interest rates. Whether this would change immediately after a rate cut to let’s say 1.5% is debatable, a rate cut would reasonably stimulate borrowing in many Eurozone countries and would also act to soften the Euro on FX markets.
A second aspect of the rate debate revolves around whether a rate cut would draw further attention towards Europe’s failings and backfire by damaging sentiment. We don’t think so. It could be argued that if the ECB cut rates from already low levels, it would further underscore the urgent need for structural reform. It would certainly undermine arguments made by a number of European politicians that the ECB isn’t doing enough to support activity and it would put the spotlight forcefully on the absence of serious political action to equip European countries to deal with the implications of the relentless worldwide drive towards greater productivity.
Any decision to cut rates will be heavily influenced by upcoming data, particular business sentiment measures such as the German IFO and consumer sentiment and spending data. Business sentiment deteriorated sharply in recent months, but some temporary stabilization to slight improvement is possible for June, as the euro weakened. Oil prices were down in May, but again sharply up in June making it difficult to assess how these have impacted the June surveys. This might give the ECB some more time of reflection and more data to assess the outlook.
At his June 2 press conference, following the ECB meeting, Mr. Trichet stuck to its vigilance mantra with regard to upside risks to price stability, even if he admitted there is only a moderate economic dynamic and most recent indicators remain on the downside. He called rates appropriate, but declined to repeat that a rate cut was no option. He insisted a few times he was not preparing the markets for a rate cut. The markets didn’t believe him and in the days after the 2-year yield fell to 2.02%, effectively discounted a reasonable chance of a rate cut further down the road. The ECB governors didn’t like that and a PR offensive was done with the objective to turn the tide and prevent the ECB to be backed in a corner. This had a temporary result, but the three events described above have unleashed market forces once again and 2-year yields dropped as low a 1.994% today. Again some governors including Noyer, Caruana and Trichet himself suggested there is no reason to change tack. The market clearly challenges the ECB point of view.
Nevertheless, barring dramatically poorer than expected data, there appears little prospect of a change in rates in July and while the ECB is scheduled to hold an interest rate policy meeting on August 4th, no press conference is scheduled and this meeting will likely be held by teleconference. This brings us to September as the earliest likely date for a rate cut. It would allow the ECB to have a better picture of the economic outlook and to have built a consensus inside the governing council, which in the past was always time consuming.
If the ECB can manage market expectations in the interim, they should be able to ease the monetary conditions facing Euro area businesses and households by prompting a modest softening in fixed term rates and, arguably of greater near-term significance, a lower Euro on FX markets. The Euro is now nearly 5 per cent below its first quarter average, which we reckon this equates to the impact of about a 50 basis point rate cut. This should assist export growth later in 2005, but to boost the Eurozone growth rate towards 2 per cent might require the equivalent of a further 25 – 50 basis points impact from some combination of lower interest rates and a weaker currency.
To be honest, there are some further good reasons why the ECB will seek to talk rather than act in the near term. The first is uncertainty about the outlook for oil prices, with the threat of $60 per barrel crude prices amplified by a softer Euro exchange rate. This causes the ECB particular problems as it threatens a deterioration in the outlook for inflation as well as activity. While very few outside the ECB believe that inflation is a problem for the EMU, on the contrary not much should happen or deflation becomes the problem, inflation stands at about 2% and will probably go slightly higher in the near term. Here is the difference with the Swedish situation.
The strong money supply growth and the abundant liquidity situation is also a hurdle for a rapid decline in rates as the monetary hardliners inside the council need probably weaker economic data to sidestep their usual objection to still lower rates.
A second reason to hold fire now would be to judge the impact of a possible near term revaluation of the Chinese renminbi, even if the timing of this event is very uncertain and has often been mistakenly announced by so-called well-informed observers. Asian currencies account for about 27 per cent of the Euro’s trade weighted exchange rate. So, a near 10 per cent average uplift of Asian currencies would be the equivalent of an ECB rate cut of around 30 basis points.
However, while the ECB may wish to push a decision further out in time, significant pressures on the ECB will come from the markets and politicians’ judgement that what Sweden needs and the Riksbank has delivered is required more urgently by the Eurozone. A major problem for the ECB in coming months is that barring unexpectedly strong data, these pressures will intensify. While we still see a rate cut as about a 50:50 proposition, markets will build in an increasing prospect of a cut with each poor economic number. The ECB will probably hope that this process will mean the exchange rate of the Euro will weaken to levels that will boost growth and lessen pressure for a rate cut. Unfortunately crossing fingers may not be
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