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Bloomberg: ECB May Consider Pause to Gauge Impact of Higher Interest Rates

February 05, 2007 | Bloomberg

The European Central Bank's toughest inflation fighters may need all their powers of persuasion to win many more interest-rate increases this year.

As oil prices hold below $60 per barrel and a German sales- tax increase fails to fuel inflation, economists say the ECB may raise borrowing costs once more in March, the seventh increment since the end of 2005, and then pause. Beyond then, economists see limited scope for further steps, a Bloomberg News survey shows.

The ECB's policy of regular rate increases over the past 14 months, advocated most forcibly by council members such as Axel Weber and Juergen Stark, may already be starting to bite. Housing markets in Spain and Ireland will probably cool this year, central banks say, and Germany's Ifo institute says the ECB needs to make sure it doesn't slow growth too much in the 13-nation region.

The ECB is ``not very far from pausing,'' said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. ``The more dovish members are making progress.''

The ECB's 19-member governing council will wait until March 8 before raising the benchmark refinancing rate by a quarter point to 3.75 percent, said all but one of 25 economists in a Bloomberg News survey. They were split about what happens after that, with only 14 predicting another increase in June.

Inflation Danger

Weber and Stark have highlighted the dangers of excessive wage and money-supply growth over the past year. Stark said Jan. 25 that the ECB has to fight any perception it accepts inflation rates above the bank's 2 percent ceiling ``on an ongoing basis'' and Weber said the next day the ``low'' level of borrowing costs is driving euro-region liquidity growth.

The ECB has failed to keep average annual inflation below its limit since 1999 and money supply expanded at the fastest pace in almost 17 years in December.

Other members of the ECB council, which is traditionally averse to airing policy differences in public, have been less strident. Portugal's Vitor Constancio said Dec. 14 inflation is ``under control,'' underscoring his reputation among some economists as a ``dove,'' less inclined to favor higher rates.

Euro-region inflation stayed at 1.9 percent in January, holding below the ECB's ceiling for a fifth month even after Merkel's sales-tax increase in Germany at the start of 2007.

`Genuine Debate'

Even Trichet has played down the significance of the surge in liquidity, saying on Jan. 11 it ``should not be overstated.''

``We're back to a genuine debate,'' said Holger Schmieding, chief European economist at Bank of America in London. ``That rates needed to go to 3.5 percent was not a big dispute. Whether you need to go further is a different question.''

Weber and Stark nevertheless say that the next wage round in Germany will be crucial in ensuring inflation expectations are kept in check. IG Metall, Europe's largest labor union, may demand pay increases of more than 7 percent in talks scheduled to start in early March.

``Wages are the biggest worry for me at the moment,'' Weber said in an interview on Jan. 26. ``We have to take this process of withdrawing monetary stimulation further.''

Luigi Speranza of BNP Paribas SA counters that productivity improvements are giving German manufacturers scope to grant pay increases of as much as 4.5 percent without fueling inflation.

``Productivity growth in the manufacturing sector will help contain the impact of higher nominal wages,'' said the London- based economist. German output per hour rose 2 percent last year after gaining 1.3 percent in 2005, outstripping the U.S. where the rate of increase slowed to 1.4 percent.


IG Metall doesn't always get what it wants. The union asked for 5 percent more pay in last year's talks and ended up with an increase of 3 percent.

The ECB has been helped by a decline in the price of oil and the euro's exchange rate. The value of a barrel of crude has dropped 22 percent since a July record of $78.40 and Europe's single currency has gained 8 percent in the past year, reducing the cost of imports.

Crude was trading at $57.26 per barrel on Feb. 2 and the euro bought $1.2971.

Those shifts are reflected in interest-rate futures trading. The implied rate on the three-month Euribor futures contract for December settlement retreated 9 basis points last week to 4.10 percent, suggesting increased doubts among investors that the central bank will go beyond 3.75 percent.

The ECB's benchmark is also approaching the so-called ``neutral'' level between 3.5 percent and 4 percent that economists say starts to act as a brake on economic growth.

``There are signs that the economy is on track, but I would be cautious to be sure that the recovery is still continuing,'' said Gernot Nerb, an economist at the Ifo institute in Munich. ``We have to see how the economy digests this tax hike in Germany.''

Weber and Stark are unlikely to shift their stance.

``I wouldn't expect them to change their rhetoric; they'll remain continuously hawkish,'' Cailloux said. All the same, ``growth is going to moderate a little more than the ECB expects and that will bring them to a pause.''


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