Wednesday, February 7, 2007

The ECB & BoE

The Central banks of the two European majors meet again this Thursday and the markets wait anxiously to see if either party is going to pull any rabbits from the hat this month.
ECB President – Jean Claude Trichet, surprised many in January when he failed to signal a rate rise for the Bank’s next meeting in February. That effectively means rates will stay on hold this Thursday. The market does however expect Trichet to resurrect the word ‘vigilance’ this week, which is a coded signal to the market for a rate hike when the MPC are to meet again, i.e. in March. However, if one looks at the data over the past month, which has been largely mixed, then the market could find itself surprised again Thursday, because there is ample justification for the ECB to hold out for longer. The crucial ingredient is consumer price inflation. Last week, Eurostat published January’s euro zone inflation estimate, which came in flat for the third month running, with an annual rate of 1.9%. Economists were expecting a rate of 2.1%. As the annual inflation rate of 1.9% is inside the ECB’s tolerance level of 2.0%, the ECB will be accused of being heavy-handed if it raises rates again against this inflation background. That in essence rules out any remote possibility of a rate hike this Thursday, but it also raises the possibility that the ECB may choose not to signal a rate hike for March either, giving it an extra month to assess fresh data. While concerns over money supply have been heightened, as M3 money continues to grow, many key business sentiment indicators have softened in the past month, indicating that growth may already have peaked. There is also the problem of the widening diversification problem between the performance of the German economy and the other major economic blocks that make up the euro zone. Against a platter of mixed signals and unknowns, the most sensible course of action for the ECB may be to wait another month and thus to deliver the same message to the market this month, as they did in January. It will be embarrassing to signal a hike now for March, if data were to dictate a different outcome later.

As for the Bank of England, their ability to surprise markets has left many with deep scars in recent months and nobody dare assume the outcome of Thursday’s meeting until the actual rate announcement itself is published on the Bank’s website. The closeness of last month’s vote, when the Bank voted to raise rates unexpectedly by a 5-4 majority, gives some insight into the difference of opinion within the current Committee. Wile debate may be seen to be healthy, the fact that the Bank’s Governor failed to deliver a more decisive vote, points to serious problems with his ability to influence the committee’s other members, which must be a major concern for the Government. To resort to having to surprise financial markets once in 6 months might be construed as a necessary evil, but to do so twice in that period signal something much more worrying. Most economists expect rates to remain on hold this Thursday, but financial markets are not so sure, with many participants deciding to err on the side of caution. It can be assumed that the 4 members who voted to keep rates on hold last time round will do so also this week, so it will only take one of the other 5 to vote with them, to maintain the current rates. What the market does not know however is what January’s inflation figure is. The MPC will have access to this data as they deliberate on their decision. It is wholly unsatisfactory that critical inflation data is not published prior to the BoE’s monetary policy meetings and this coincidently is the principal reason why markets are so susceptible to surprise rate hikes. Had markets gotten print of the 3.0% CPI figure in January, prior to a rate announcement, then financial markets would have priced in a high probability of a rate rise in January, rather than February. Economic data out of the UK has, for the most part, been firm over the past month and the danger must be that inflation will not have dissipated at all, but in fact it may have appreciated again. Against this backdrop and given he market has fully priced in a rate hike for March, could the MPC hike rates again this week? December/ January is a traditional spending time of the year for UK consumers and house markets are in non-seasonal mode, so it might be premature for the MPC to rise rates so quickly again. Indeed, the real impact of both the November and January rate hikes could take a few months to impact on economic data, so a further hike now could seriously damage the economy in the medium to longer term. But given the MPC’s recent track record, should we be surprised?