ECB Preview: Decoding a July Hike, "Very Close Monitoring"

• We expect the ECB meeting on Thursday to be an intermezzo. We expect Jean- Claude Trichet to use the wording "very close monitoring" to signal that the next hike is two months away.
• However, the use of "monitor very closely" signalling at least two months to the next hike cannot be ruled out.
• We only see a 15% chance that Trichet will use the "strong vigilance" code this Thursday to signal a June hike.
• Trichet is likely wait and send the "strong vigilance" signal at the June meeting. Hence, we stick to our expectation of a hike in July.
• We expect the ECB to make additional hikes in October 2011 and January 2012. The ECB may decide to take a pause after four hikes when the refinancing rate hits 2.0%.
• If Trichet signals a July hike the market reaction should be muted. However, as we attach a minor probability of Trichet opening the door for a June hike we see risks skewed moderately for higher short-end rates going into the meeting on Thursday.
• The fragile state of the euro area banking sector and the increased risk of further escalation of the debt crisis has increased the likelihood that the ECB will continue with full allotment on all auctions until early-2012.

Decoding a July hike – "Very close monitoring"

We expect the meeting on Thursday to be an intermezzo before the strong "vigilance" signal is used again at the June meeting to signal a July hike. Trichet will likely use the wording "very close monitoring" to signal that the next hike is two months away. This phrase was used in February this year and also in January and April 2007 to indicate that the next hike was two month away. In January the ECB switched from "monitor very closely" to "very close monitoring", which was a warning that a hike was moving closer and could have come as early as March. However, this also highlights that these signal are not perfect predictors, since it took three and not two month before the hike was delivered. But remember, the ECB never pre-commits.

Alternatively, Trichet could use the wording "monitor very closely", which has previously been used two months ahead of the next hike. This wording could, however, also indicate that the next hike is further away.

We only see a 15% chance that Trichet will use the "strong vigilance" code to signal a June hike. Finally, the use of "appropriate" could in theory be used to signal an ending of the hiking cycle, but we deem this message to be very unlikely given the recent surge in inflation.

Inflation continues upward – currently at a two-year high

That "upside risk" to inflation was highlighted with the very high April reading of 2.84% released last week. We are now far from the ECB target of "below but close to 2%". Inflation has been increasing sharply lately and details on the March reading showed that the main driver remains energy prices but also core inflation has started to pick up, which isn't very comforting for the ECB. The ECB's main concern is that imported inflation could lead to second round effects. Inflation might increase to more than 3% this summer and is projected to remain elevated until early next year. We expect the ECB to use this window to increase rates at a moderate pace to 2%.

Recall that the use of the new harmonised correction of prices on seasonal goods has created additional uncertainty about the monthly inflation figures throughout 2011 and may lift inflation by as much as 0.2 percentage points this year. This is a purely statistical effect, however.

The ECB quarterly staff inflation projections of 2.3% in 2011 and 1.7% in 2012 are substantially below our expectations and will almost certainly be revised up in June. At this meeting Trichet is likely to emphasise that upside risk to the inflation outlook remains, especially following the high inflation number for April.

The Italian central bank governor Mario Draghi is almost certain to be inaugurated as the next ECB president on November 2011. He needs to show that he is an Italian with a German mind and is therefore likely to take a tough stance on inflation from the beginning. Furthermore, seven governing council members will change seats this year, which it has been argued should prompt a slightly more hawkish ECB.

Normalisation not before 2012

A disappointing bank lending survey released last week and the ongoing situation with Greek sovereign debt has caused us to believe that we will not see a normalisation until 2012. That means that the ECB will continue with full allotment on both MRO and LTRO. However Trichet will not elaborate on this before the rendezvous at the June meeting. The ECB's bank lending survey stated that credit standards had been tightened in Q1 and this is expected to continue in Q2 (see Euro area: Credit tightening in Q1 may slow ECB's exit pace). This could indicate that the euro area banks are still not doing as well as one could hope for and/or that the balance sheet consolidation is influencing credit standards. With increasing rates we do not believe that the ECB perceives it appropriate to proceed with normalisation until next year.

Market reaction

Market pricing currently implies that the ECB will hike by 25bp at its July and October meeting and then further in February 2012 – assuming that the spread between 1M Eonia and the Refi-rate stands at 15bp. In the main scenario, in which Trichet signals a July hike the market reaction should thus be muted. However, as we attach minor probability of Trichet opening the door for a June hike we see risks skewed moderately for higher shortend rates going in to the meeting on Thursday.

comments from ECB Governing Council members

Jean-Claude Trichet (ECB President, France), 2 May

"The fact that we have been able to solidly anchor inflation expectations in the euro area at a level consistent with price stability throughout all these phases has bolstered our credibility."

"The Eurosystem has kept and will keep its sense of direction, strictly separating the standard measures, designed to deliver price stability, form the non-standard measures, designed to help restore a more correct monetary policy transmission mechanism"

Vitor Constancio (ECB Vice-President, Portugal), 2 May

"Restructuring Greek debt not on the table"

"Greece must stick to consolidation programme"...

Nout Wellink (GC Netherlands), 2 May

"We have done extraordinary things. But we're not here to finance governments,"

"It is forbidden to finance governments and in the long-term it will lead to inflation. And that is against our mandate"

Jean-Claude Trichet (ECB President, France), 18 April

"Will not accept second-round effects"

"Until now, I do not see alarming second-round effects,"... "There are some signs here and there that are not going in the right direction,"

Jose Manuel Gonzalez-Paramo (EB Spain), 14 April

"All in all, risks to growth are balanced and risks to inflation are on the upside," Lorenzo Bini Smaghi (EB Italy), 14 April

"The minimum levels at which the interest rates were standing were justified by the 2009 recession and the risks of deflation,"

"As we move away from those risks, the less justified these interest rate levels are."

"The most recent data, as well as the International Monetary Fund forecasts, seem to confirm the scenario of sustained global growth, which is also transmitted to the euro."

Juergen Stark (EB Germany), April 12

"The ECB will adjust its policy interest rates and its provision of liquidity at a pace and to a degree commensurate with the evolution of risks to price stability and as appropriate to maintain an orderly and functional monetary policy transmission,"

"As with the phasing-in of non-standard measures, there are no pre-defined steps between phasing them out and exiting from very low policy interest rates."

"The maintenance of price stability over the medium term guides all monetary policy decisions,"