When the financial markets crisis erupted, the ECB was enjoying the widespread acknowledgement of a remarkable improvement in its credibility and reputation under the Trichet’s presidency. First, there had been the great call of December 2005 when the central bank, relying on a sanguine growth outlook, began its tightening campaign amidst the general skepticism. Then, the wise Trichet’s management of communication, made by a good blend of keywords and carefully low commitment raised massively the ECB’s status among investors and made possible a high degree of effectiveness in monetary policy. In our opinion, so far the crisis management could have hardly been better given the high uncertainty on financial markets prospects and the suddenly deteriorated sentiment among economic agents. Keep in mind that the crisis caught the ECB a few days after it has telegraphed a rate hike to the markets and at the eve of an abrupt spike in headline inflation. Certainly, the central bank cannot be blamed for the persistence of money market dislocations, which are the consequence the pernicious information crunch on the actual size and distribution of losses among financial intermediaries.
At the same time, the ECB cannot ignore the massive increase in headwinds the economy will face over the very next quarters. We have just entered the fifth month of financial crisis: credit conditions are tighter, business and consumer confidence are trending down, and export competitiveness is being hit. Chances that next year growth will be below potential – with further downside risks – are rising by the day. Policy rates on hold, with lower real rates to support the cycle, for a long while seems the most plausible (and appropriate) option. With risks to growth tilted to the downside and the bulk of the weakness concentrated in the first half of the year, probabilities of a rate cut in H1 2008 are not negligible, although we do not subscribe to the virtual certainty the short end of the yield curve assigns to such a scenario. Under the assumption that the US economy does not precipitate into a recession spiral, and that money markets normalize within the next spring (which seems the most plausible option for the majority of the Council), the ECB should be able to “resist” market pressures and try to sustain the cycle via lower real interest rates, while retaining a hawkish stance to keep a lid on inflation expectations. And, indeed, probably like never before inflation expectations will be the name of the game when it comes to the 2008 monetary policy outlook.
One of the few novelties brought about by the recent ECB-speak has been the remark made by Axel Weber on the subtle but relevant difference between the tightening in monetary conditions occurred because of the financial crisis and the actual tightening achieved via higher policy rates. Weber’s point is that only the latter is able to steer effectively long-term price expectations, hence everybody should work on the assumption that as monetary conditions ease…the ECB “may need to tighten rates further”. The traditional ECB’s steady-hand approach contemplates a monetary response to commodity-induced inflation jumps only if they portend undesired second-round effects. What keeps the ECB with the eyes wide open is that the unfavorable base effect on energy has accompanied an upward shift in food inflation. The result of the coincident increase in the price of two key components of primary spending has been a rise in inflation expectations, mainly at a survey level but also in market measures.
Inflation expectations are climbing
Source: European Commission, Bloomberg, UniCredit Global Research
The chart shows how inflation expectations have increased of late. The 5y5y inflation swap rose by almost 10 basis points since the end of August, whereas household expectations computed by the European Commission are now at 28.3 (last May they were at 16.8), more than one standard deviation above their average since 1999. Other measures of expectations from market professionals (Consensus Economics, the Economist Intelligence Unit, the SPF) have either inched up marginally or stayed put at around 2%. However, following the recent jump to 3%, these measures will likely be revised upward significantly. As discussed in another section, we see 2008 inflation averaging 2.4%.
In order to introduce some methodological elements in the “Great Divide” – as we labeled it – between the ECB rhetoric and market expectations, we estimated a slightly modified version of our real time survey-based Taylor rule. The two explanatory variables are a gauge of the output gap derived by our composite PMI and a measure of inflation expectations, in order to take into account of the ECB medium-term approach. We ran the model several times based on different measures of inflation expectations (including the ECB staff projections) and found that all measures of inflation expectations outperform actual inflation’s explanatory power.
A simple Taylor rule points to some easing in H1 2008
The estimate based on the EIU inflation expectations has the best fit, although in the last part of the recent cycle has underestimated the actual level of the refi rate. We assume that in sympathy with our baseline scenario, next year the output gap moderately shrinks in the first part of the year, before widening again in H2 2008, and that EIU expectations on 2009 inflation will average 2.1%. Under such assumptions, the Taylor rule predicts some easing in the first part of next year. We would take these results – perfectly matching what the market is currently pricing – with a pinch of salt, and continue to think that the most compelling argument in favour of our view of rates unchanged is the recent surge in inflation expectations. Unless the euro climbs to 1.60 against the dollar and/or the current market crisis spills over to the real economy via a massive credit rationing, the ECB history plays in favour of no news on the rates front.