Euroland: In Defense of Price Stability

Difficult decisions ahead for the ECB… On our forecasts, the mix between growth and inflation will be considerably less favourable next year. At 1.6% on average, real GDP growth will likely fall below trend, at least during the first half of the year. At the same time, consumer price inflation will likely remain rather elevated well into the second half the year and might not ease back into the ECB’s tolerance zone at all next year. Due to its clear mandate, the inflation outlook takes precedence for the ECB in its monetary policy decisions. It will be more important than the growth outlook, at least as long as inflation is still in overshoot territory and as long as the risks to price stability are on the upside. On balance, we therefore expect the Bank to remain on hold at 4% next year. While this is the central case, there is a notable shift in the risk scenario in the course of the year. Given the hawkish tone of the December press conference and the clear tightening bias the ECB maintains at the moment, in the early part of the year the risk scenario is that of an additional rate hike. In the course of the year, the risk scenario flip-flops to that of a rate cut. However, a refi rate cut could become a reality, we think, if the credit crisis takes another major turn to the worse or if the euro significantly breaks above 1.50 versus the US dollar. Vice versa, a refi rate hike could be on the cards, if tensions in the credit markets suddenly dissipate in the new year. Both scenarios aren’t what we expect though. And the hurdles for an interest rate adjustment in both directions are rather high, we think. Hence unchanged interest rates are the most likely scenario for 2008, in our view.

…if it wants to be true to its mandate. But it is important to bear in mind that contrary to the Federal Reserve and the Bank of England, the ECB’s tightening campaign brought euro area policy rates back to a broadly neutral level, but not a restrictive level. The need to ease monetary policy is therefore less pronounced for the ECB, we think. In addition, domestic demand growth – notably consumer spending – in the euro area hasn’t been driven by debt dynamics to the same extent as in the US or the UK. As a result, the risks of a recession on the European Continent remain remote. For the prospects of rate reductions in the euro area much will depend on whether, in the view of the Governing Council, the recent rise in energy and food prices, which pushed headline HICP inflation up to 3%Y in November, could translate into so-called second round effects via higher wage demands and other price increases. The emergence of serious second round effects would likely force the ECB’s hand. The robust labour market dynamics and the rising role of minimum wages will cause wage inflation to pick up to 2.7% next year, the highest growth rate since 2001. Again, the eyes of the ECB Council are likely to rest on Germany, where wage talks are starting in early 2008 and which so far has been a moderating factor for euro area wage dynamics.

A rate cut is a possibility, but not a probability. While we do not rule out ECB interest rate reductions in the course of the next year, we believe the dataflow will have to deteriorate considerably before interest rates cuts can be considered a main case scenario. So far, activity indicators do not point to pronounced shortfall of growth below trend. We therefore would probably need to see business sentiment falling to — and eventually below — its long-term average. In addition, money and credit statistics, as well as the ECB’s own bank lending survey, would need to convince Council Members that credit conditions for investment in physical capital such as machinery, equipment or structures have become overly tight. Last but not least, well-anchored inflation expectations as well as moderate wage demands would need to signal to the Bank that the current overshoot in HICP inflation is likely to remain temporary. The starting point of the ECB’s deliberations, though, is that cyclical inflation risks have emerged in the course of the last 12 months, which would warrant further tightening if it wasn’t for the uncertainty and the downside risks to growth created by the current credit market crisis.

Keeping liquidity management separate from monetary policy

Next to gauging the macroeconomic implications of the current credit market tensions, the ECB also faces the challenge to ensure orderly functioning of the euro area money market against a backdrop of rapidly rising risk aversion. Not only is this operational side also part of the Bank’s mandate it is also essential to ensure that, if needed, the monetary transmission mechanism is fully functional. Given the fragmentation of the euro-area banking system, the absence of a Pan-European regulator and the multiplicity of national supervision, the ECB’s task is somewhat trickier than that of other central banks. Its fast and forthright reaction to the market tensions over the last few months show that the ECB is well aware of the situation. In addition, its two-pillar strategy not only allows but forces the bank to carefully judge the implications of the trends observed in money and credit growth for the medium to long-term inflation outlook. The clear focus on monetary variables, in my mind, makes it unlikely that we will see a repeat of the Japanese experience in the euro area.

Bond yields are set to rise. So is volatility. Against the backdrop of a renewed economic recovery in the second half of the year, rising long-term inflation expectations and higher near-term uncertainty, we expect ten-year Bund yields to rise significantly above 4% in the course of 2008. Our year-end target is 4.5% for ten-year government bonds. The violent moves over the last few weeks are a timely reminder of the uncertainties surrounding such yield forecasts. The yield curve is expected to steepen for two reasons. First, unless that US economy ends up in a prolonged structural crisis, signs of recovery should become visible in the course of the year. Second, in the event of an ECB refi rate cut or if the market starts to believe that the ECB is going to lower rates, the front-end has some scope to rally. On the whole, 2008 will likely be a volatile year for bond markets, we think. Investors will be torn between the downside risks to growth and the upside risks to inflation. An additional risk stems from potential flight-to-quality on the back of a renewed downturn in the credit market and potential asset reallocation trades in the face of the equity bear market that our equity strategists forecast for next year. As a result, we cannot rule out that ten-year bond yields could break the 4% level also in the euro area in the first half of 2008. But at this stage, we believe that we likely have seen the lows in bond yields.

By Elga Bartsch London
Morgan Stanley
December 16, 2007