As was widely expected, the European Central Bank increased its key interest rate by 25 basis points to 1.25% on Thursday. At a press conference following the rate decision, ECB President Jean-Claude Trichet announced that though the rate has been hiked with the objective of reining in medium-term inflationary pressures, it does not necessarily mark the first in a series of monetary policy changes in the coming months. Rather, Trichet simply said that the ECB will continue to stringently following its inflation targeting mandate and take necessary measures if needed.
Ahead of the ECB news, the Bank of England announced that it is keeping its base interest rate and asset purchase programme target unchanged. The US Federal Reserve monetary policy meeting will be held on April 27.
In the aftermath of today’s news, the euro softened against the dollar but the pair remained relatively stable in the face of the ECB interest rate change. The latter had been largely priced in, thus currency markets were instead responding to the reserved tone and cautious comments with which Trichet addressed questions on future monetary policy and eurozone growth expectations.
Trichet’s statement was “more dovish” than expected and the ECB kept “their cards close to their chest,” commented Kathleen Brooks, Research Director at GAIN Capital. Shortly before the ECB decision was announced, she said that a hike in the current environment would signal the beginning of an interest rate “normalisation cycle,” whereby central banks will seek to return borrowing rates to their pre-crisis levels. In Brooks’ view, Trichet’s verbal vigilance has made this outlook more difficult to pinpoint with precision, but the process of interest rate increases has been kick-started nonetheless. Brooks expects two hikes of 25 basis points in the third and fourth quarters, though she believes these have been already priced in by the market.
Peter Hensman, Global Strategist at Newton Investment Management, agreed on the prospect of future ECB rate hikes. Although the Governing Council did not decide that this was the start of a series of rate increases, the fact that the ECB sees upside risks to inflation remaining indicates that further increases are likely, he said.
The ECB Balancing Act
The ECB’s preoccupation with inflationary risks and its determination to operate within the inflation-targeting mandate back up the argument that this interest rate rise could be the first of several. In Trichet’s own words, “the adjustment of the current very accommodative monetary policy stance is warranted in the light of upside risks to price stability that we have identified in our economic analysis.”
This view is, of course, counterbalanced by the prospects of fragile and divergent economic growth within the eurozone. The ECB maintained that anchoring medium term inflation expectations in line with the its aim to keep inflation rates below, but close to, 2% is a “prerequisite for monetary policy to contribute to economic growth” across both the periphery and the core of the eurozone.
The ECB did not deny that while the underlying momentum for economic activity still looks positive, “uncertainty remains elevated.” The assessment of Europe’s growth pressures appear fair, if not understated, especially given that Portugal today formally asked the EU for financial assistance while Spain yesterday downgraded its growth forecast and witnessed a services sector contraction earlier this week.
It could be said that balancing the monetary policy needs of economies of varying size, growth rate and level of development is a challenge inherent to the common currency project and the current climate presents an extreme version of this reality. “While an interest rate rise suits the booming German economy, rate rises will hit leveraged households in Portugal, Ireland, Spain and Greece and the short term economic outlook for these economies is nothing less than grim,” explained Charles Davis, Managing Economist at Cebr. Davis joins Brooks and Hensman in saying that a further rate rise from the ECB cannot be ruled out, which prompts him to expect weak growth in the eurozone as a whole.
Parus Shah, Portfolio Manager of Fidelity’s European Special Situations Fund, disagrees: “European GDP growth will be stronger than what the consensus is forecasting due to the strength of the eurozone’s ‘core’ countries offsetting weaknesses in the periphery.”
A Central Bank Trilemma
While Trichet was careful not to suggest that the ECB is striving for leadership on the monetary policy front, it is true that the Frankfurt-based bank moving interest rates before London or Washington is unprecedented. Given that today’s hike was minimal in size and there is little clarity on when the next move might be agreed upon, there are limits to what insights the ECB decision can provide into global monetary policy dynamics and their reflection on commodity, bond or equity markets going forward.
One potential outcome is that higher interest rates in the eurozone support the common currency against the dollar, which could in turn contribute to commodity inflation. There are historical precedents to support this view, said Kathleen Brooks, though she added that eurozone monetary policy is only one factor that impacts EUR/USD dynamics, as well as energy markets supply and demand pressures. For this reason, Brooks points to the Federal Open Market Committee’s next meeting as an important focal point for investors. The rate decision will be followed by one of the four post-FOMC meeting press conferences Chairman Ben Bernanke is scheduled to give this year, and Brooks believes these will help bring clarity to market expectations.
In London, an interest rate increase is broadly expected before the end of 2011, but opinions diverge on the exact timing. According to the Cebr, “this ECB move could pave the way for a 25 basis point rate rise by the Bank of England next month.” Brooks takes a different view. She believes soft economic growth makes increasing UK interest rates sooner rather than later “madness” and does not rule out a rate change being pushed back to the fourth quarter of the year. In fact, Brooks commented that the relatively dovish tone of today’s ECB press conference could take some of the pressure off Threadneedle Street. Talking at a recent inflation debate, M&G Inflation-Linked Corporate Bond fund manager Jim Leaviss commented that the BoE may feel the need to push out one rate increase this year for credibility’s sake.
Market Impact
Equity markets in London and Frankfurt toyed with the breakeven line as the Bank of England and the ECB made their rate announcements today, suggesting little market conviction in the impact from monetary policy changes, or lack there of, on risk appetite.
On a macroeconomic level, Trichet repeatedly pointed out that neither growth fundamentals, nor the stability of peripheral eurozone sovereigns or their bank sectors will be endangered by the change in ECB monetary policy.
In line with this view that the core will continue growing strong while the periphery will lag, Fidelity’s Shah commented that “there are sectors and countries which will do significantly better than others, providing good long and short stock picking ideas.”
On a company-by-company basis, valuations of eurozone-listed companies have been largely sited as attractive of late and this is precisely the tailwind for investing in the EU that fund managers have recently outlined. At the same time, incremental changes to interest rates will hardly be sufficient to reverse the recent trend of assets flowing away from fixed income and into risk-on equity plays.
In terms of market impact, Brooks summed up popular sentiment in saying that investors have become used to the “unknown unknowns” which will support equity market performance for the rest of the second quarter.
