ECB: possible rate hike in April

  • Trichet announces that a 25 basis point rate hike is likely as early as April
  • The ECB is set to risk starting the tightening cycle too early
  • Weakest Member States likely to be weakened by the decision
  • At the same time, nonstandard measures are maintained at least until the end of Q2
  • Accordingly, we have revised our interest rates forecast. The tightening cycle is frontloaded. The repo rate may reach 2% by the end of the year

Very hawkish press conference
Today’s press conference showed a very hawkish Jean-Claude Trichet. After an introductory statement in which he did not say that rates were “still appropriate”, where he stressed that “risks to price developments are on the upside”, that the current monetary stance was very accommodative”, he used the famous wording used to announce an imminent rate hike: the Governing Council is adopting a posture of strong vigilance“. In fact, he took advantage of the Q&A session to be very explicit on the following course: “… my understanding of the position of the Governing Council… is that an increase in interest rates in the next meeting is possible”. He softened his statement somewhat by using the usual disclaimers: “We are never precommitted”, “it is not certain, is possible”, “it is certainly not a start of a series of interest rate increases”.

Low interest rates have made the ECB nervous
The decision has clearly been motivated by the rising inflationary pressure, the particularly low level of real interest rates and the encouraging economic outlook. In this regard, the ECB’s staff projections have been revised up to be between 1.3% and 2.1% for GDP growth in 2011 and between 0.8% and 2.8% in 2012. Inflation projections were also revised up to between 2.0% and 2.6 for 2011 and between 1.0% and 2.4% for 2012.

Non-standard measures maintained
At the same time, the ECB decided to maintain its liquidity supply at fixed rate and full allotment until the end of Q2. At this point we may well wonder why the ECB would increase interest rates while it continues to allow an extensive supply of liquidity? Firstly because, by increasing the price of its liquidity, the ECB will create an incentive for banks to mobilise their hoarded liquidity. A normalisation of market rates may be the result. Secondly, the move appears to be politically motivated. It is a way of showing that the ECB is able to flex its muscles at a time when delicate, wide-ranging negotiations on the future of the European Union are taking place. It is difficult not to think back to July 2008, when the ECB increased rates when all indicators were pointing south and it had to reverse its decision just a few weeks later.

Intervention rate likely to gradually increase up to 2%
In any case, interest rates have not yet been raised. However, unless some very negative events take place in the meantime, it is very likely that the ECB will increase its intervention rates by 25 basis points in April. The real question is what next? They will probably continue to increase rates at a gentle pace, 25 basis points per quarter, provided that the economic outlook remains favourable. At this pace the repo is likely to reach 2% by the end of the year.

This will certainly increase the pressure on the weaker Member States.
Portugal will probably be pushed into asking for international help. So divergence between the periphery and the rest of the euro area is likely to persist for some time or even increase during 2011. This decision will also boost the euro on the short term, although its favourable impact may rapidly evaporate if the recovery shows signs of weakness.

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