Monday, December 3, 2007

Market Watch - ECB December 6

What to expect from the ECB

The ECB’s Monetary Policy Committee delivers its final rate verdict of the year on Thursday next. It is 100% certain rates will be unchanged for the sixth consecutive month, meaning the baseline interest rate for the euro area will remain at 4.0% into 2008. While the rate outcome seems not in doubt, of more significance to markets is the accompanying statement and the precise language used by Jean Claude Trichet, the ECB President, when he presides over the customary press conference, 1 hour and 15 minutes after the official rate announcement. During the whole global credit crisis, which first befell financial markets back in August, the ECB maintained its hawkish bias throughout. This week the MPC finds itself between a rock and a hard place, as recent economic data points to a cooling in the euro economy, credit woes are worsening in financial markets, while euro area inflation hit a 6 year high in November. Dovish comments have begun to emanate from ECB council members, particularly as the euro’s rapid appreciation is now causing considerable disquiet within some euro nations, most notably France. With the Fed signalling further rate cuts in the US, the ECB stands accused by many of merely sitting on its laurels and allowing the Fed to take full responsibility for alleviating a credit crisis that engulfs not just the US stock market and banking sectors, but all of the world’s major financial markets.

It was a safe bet a few weeks ago to expect the ECB to significantly qualify their tone this week and to release a more neutral policy statement, balancing upside inflation risks with downside growth risks. This may still be the essence of the message Trichet delivers next Thursday, but given the ECB’s preoccupation with price stability and inflation, which it argues is its only remit, can the ECB seriously afford to sound more dovish at a time when inflation has suddenly hit a worrying peak? I recall a comment made by the ECB’s Weber a couple of months ago, which caused quite a stir in global stock markets at the time. Weber suggested the ECB may have to continue to raise interest rates, even if the euro economy hit a significant downturn, in order to keep inflation under control. This argument could form the crux of the debate when the ECB deliberates this week.

I suspect the MPC will maintain its inflation bias, for to do anything else might undermine their authority and consistency. Trichet will talk up the downside risks to growth for sure. I don't expect Trichet to refer directly to the strength of the euro in his statement, although he will probably reiterate the ‘brutal movements in currency markets are unwelcome’ comment during his Q&A session. Maintaining a hawkish bias now will not prevent the ECB from cutting rates at any point in the near future, if an easing move is deemed necessary, i.e. if financial markets are not functioning properly. On the other hand the ECB is unlikely to signal any imminent rate hike, despite inflation having risen to levels well above the ECB’s comfort zone. It will be interesting to hear what the ECB forecaast for inflation into 2008, which when taken together with the Bank's growth forecasts, will at least give some indication of where rates may go next year.

Don’t expect too much of a shift in ECB policy stance Thursday and with little hope of any major shift to a more dovish stance in the near future, the rate differential outlook fo the euro Vs the dollar still very much favours the euro, as we come to the end of this year.

Ted B - Dec 2

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