Friday, April 8, 2011

ECB pulls the trigger

As was widely expected, because they told us they were going to do it, the European Central Bank (ECB) raised interest rates overnight. The Bank raised the benchmark rate 25 basis points from 1.0% to 1.25%.

In terms of where to from here, the key phrase was "(while) we did not decide it was the first in a series of interest rate increases, you know from our own doctrine that we always do what is necessary to deliver price stability over the medium term."

As you know we have been in favour of an early and gradual approach to the withdrawal of monetary stimulus in the various markets where monetary conditions were eased agressively during the Great Recession. The qualification we added to that was "when the time is right."

I like the gradual approach the ECB wants to take to what you could also call the "normalisation" of monetary policy. Agressive tightenings in monetary conditions are not required at this stage. But we do worry that the Bank may have started the process a tad too early. Financial and economic conditions are still fragile in Europe, especially in the periphery. Starting now is a risky strategy. Furthermore, fiscal policy is playing a significant part in the withdrawal of stimulus.

One of the biggest risks is the ECB is putting too much weight on economic developments in Germany. In so doing they are under-estimating the impact of higher interest rates in the weaker parts of Europe. When Trichet says that "It is essential that recent price developments do not give rise to broad-based inflationary pressures over the medium term," he seems to me to be talking specifically about Germany.

While the Bank has stated this is not neceassarily the start of a series of interest rate increases, you don't start a process like this without thinking you want to get interest rates somewhere higher than just 25bp away. But they can take a gradual approach. At this point I wouldn't expect to see another tightening until June.

In other monetary policy developments this week, the increase in Europe interest rates came just a few days after a fourth increase in rates in China. There are clear signs that the pace of economic growth in China is slowing, however we think there is more tightening to come. Interest rates were left unchanged by the Bank of England and the Bank of Japan. Strong jobs growth data in Australia released yesterday suggests further monetary policy tighteing will be required there this year.