Posted on Monday, 2nd May 2011 by Charlotte W
Decoding a July hike – “Very close monitoring”
We expect the meeting on Thursday to be an intermezzo before the strong “vigilance” signal is used again at the June meeting to signal a July hike. Trichet will likely use the wording “very close monitoring” to signal that the next hike is two months away.
This phrase was used in February this year and also in January and April 2007 to indicate that the next hike was two month away. In January the ECB switched from “monitor very closely” to “very close monitoring”, which was a warning that a hike was moving closer and could have come as early as March. However, this also highlights that these signal are not perfect predictors, since it took three and not two month before the hike was delivered. But remember, the ECB never pre-commits.
Alternatively, Trichet could use the wording “monitor very closely”, which has previously been used two months ahead of the next hike. This wording could, however, also indicate that the next hike is further away.
We only see a 15% chance that Trichet will use the “strong vigilance” code to signal a June hike. Finally, the use of “appropriate” could in theory be used to signal an ending of the hiking cycle, but we deem this message to be very unlikely given the recent surge in inflation.
Inflation continues upward – currently at a two-year high
That “upside risk” to inflation was highlighted with the very high April reading of 2.84% released last week. We are now far from the ECB target of “below but close to 2%”. Inflation has been increasing sharply lately and details on the March reading showed that the main driver remains energy prices but also core inflation has started to pick up, which isn’t very comforting for the ECB. The ECB’s main concern is that imported inflation could lead to second round effects. Inflation might increase to more than 3% this summer and is projected to remain elevated until early next year. We expect the ECB to use this window to increase rates at a moderate pace to 2%.
Recall that the use of the new harmonised correction of prices on seasonal goods has created additional uncertainty about the monthly inflation figures throughout 2011 and may lift inflation by as much as 0.2 percentage points this year. This is a purely statistical effect, however.
The ECB quarterly staff inflation projections of 2.3% in 2011 and 1.7% in 2012 are substantially below our expectations and will almost certainly be revised up in June. At this meeting Trichet is likely to emphasise that upside risk to the inflation outlook remains, especially following the high inflation number for April.
The Italian central bank governor Mario Draghi is almost certain to be inaugurated as the next ECB president on November 2011. He needs to show that he is an Italian with a German mind and is therefore likely to take a tough stance on inflation from the beginning. Furthermore, seven governing council members will change seats this year, which it has been argued should prompt a slightly more hawkish ECB.
Normalisation not before 2012
A disappointing bank lending survey released last week and the ongoing situation with Greek sovereign debt has caused us to believe that we will not see a normalisation until 2012. That means that the ECB will continue with full allotment on both MRO and LTRO. However Trichet will not elaborate on this before the rendezvous at the June meeting. The ECB’s bank lending survey stated that credit standards had been tightened in Q1 and this is expected to continue in Q2 (see Euro area: Credit tightening in Q1 may slow ECB’s exit pace). This could indicate that the euro area banks are still not doing as well as one could hope for and/or that the balance sheet consolidation is influencing credit standards. With increasing rates we do not believe that the ECB perceives it appropriate to proceed with normalisation until next year.
Market reaction
Market pricing currently implies that the ECB will hike by 25bp at its July and October meeting and then further in February 2012 – assuming that the spread between 1M Eonia and the Refi-rate stands at 15bp. In the main scenario, in which Trichet signals a July hike the market reaction should thus be muted. However, as we attach minor probability of Trichet opening the door for a June hike we see risks skewed moderately for higher shortend rates going in to the meeting on Thursday.
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Tags: Close Monitoring, July Hike, Monitoring
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