ECB Preview: Trichet Will Signal a July Hike

• We expect Jean-Claude Trichet to deliver the "strong vigilance" signal at the ECB meeting on Thursday. In fact, we only see a five percent chance that Trichet will use "monitor very closely", which would imply that a July hike is not on the cards.
• The argument for the ECB to hike rates has weakened recently, but strong economic growth in Q1, high headline inflation and rising inflation expectations are nevertheless expected to prompt the ECB to deliver a July hike.
• ECB will revise its quarterly staff projections for both inflation and growth upward in particular for 2011. This gives Trichet some additional ammunition for hiking rates in July.
• We also expect the ECB to deliver additional hikes in October 2011 and January 2012, but risks are currently tilted towards the ECB delivering fewer hikes or at a slower pace than in our main scenario.
• Given the fragile state of the euro area banking sector and the risk of a further escalation in the debt crisis, we expect the ECB to continue with full allotment on all auctions until early 2012.
• We think current market pricing looks soft and expect rates to move some 5-10 basis points higher across the money market curve on confirmation that a hawkish ECB will hike rates in July.

Arguments for a hike have weakened recently

The argument for the ECB to hike rates has weakened recently. After a sharp decline in monthly loan flows the monetary analysis no longer indicates that the ECB should hike rates. The hiking signals from our ‘speed limit approach' based on PMI new orders have also vanished.

Strong economic growth in Q1, high headline inflation and rising inflation expectations are nevertheless expected to prompt the ECB to deliver a July hike. We thus expect Trichet to come out with the words "strong vigilance" on Thursday. This is in line with market expectations. Recent comments from ECB Governing Council members have not done anything to change this perception. Overall, we estimate the likelihood of "strong vigilance" at 95%.

The ECB has clearly stated that it isn't comfortable with the current very low interest rates, as it limits the room for manoeuvrability and "can inspire risky business strategies" (see speech by Bini Smaghi). High headline inflation now provides the ECB with a window of opportunity to partially normalise interest rates. If this opportunity is not used, the ECB could be stuck with low rates for an extended period. We expect inflation to decline and the window of opportunity for the ECB to close in early 2012.

Whether the ECB continues to hike rates after July depends on how fast the various indicators fade. Headline inflation will stay above ECB target throughout the year, but if inflation expectations decline in combination with a continued weakening of the soft indicators - possibly combined with an escalation in the debt crisis - support for further rate hikes could vanish. (For more on hiking signals, see ECB: How fast and for how long will the ECB hike rates?).

Overall, risks are currently tilted towards the ECB delivering fewer hikes or at a slower pace than in our main scenario (hikes in July, October and January 2011).

Staff projections to be revised up

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. We project that inflation will remain elevated throughout 2011. Core inflation has been picking up recently, which could be an early sign of second-round effects. We forecast HICP inflation to reach 2.7% in 2011 and 2.0% in 2012.

The ECB growth projections will also be revised upward. In its March projections, the ECB expected growth to be 1.7% in 2011 and 1.8% in 2012. We now expect growth to be 2.2% in 2011 and 1.9% in 2012.

Upward revisions of both growth and inflation forecasts provide the ECB with additional ammunition for hiking rates.

Normalisation in 2012

It is time for a rendezvous on normalisation of refinancing operations. A disappointing bank lending survey released and the ongoing situation with Greek sovereign debt has led us to believe that the ECB will continue with full allotment in both the main refinancing operations (MRO) and the long-term refinancing operations (LTRO). Currently, we do not expect to see a normalisation until early 2012, which could be announced at the December meeting.

Market reaction

Based on current market pricing we look for moderate upside risks to European money market rates when Trichet signals that a July hike is on the cards. A July hike is already more or less fully discounted in the curve limiting upside in the very short end. However, post July, market pricing has softened recently, implying only one further 25bp hike to 1.75% on a 12-month horizon (assuming money markets will be normalised at that time). We think that current market pricing looks soft and expect rates to move some 5-10bp higher across the money market curve on confirmation that the ECB will move in July

Recent comments from ECB Governing Council members

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

"ECB's primary objective is price stability"

"We showed our responsibility in taking monetary policy measures - we call them "non standard" decisions, strictly separated from the "standard" decisions, and aimed at restoring a better transmission of our monetary policy in these abnormal market conditions."

Juergen Stark (EB Germany), 1 June

"ECB won't tolerate second-round effects."

"ECB monitoring risks very closely."

Jean-Claude Trichet (ECB President, France), 28 May

"The prices of oil and raw materials have risen worldwide. This is also pushing up the consumer price index in the euro area. Our responsibility is to prevent pricesetters and social partners from increasing other prices and wages in the medium term. We are there to prevent these second-round effects."

Lorenzo Bini Smaghi (EB Italy), 26 May

"The standard monetary policy instrument has been used to pursue the ECB's primary objective of price stability in the euro area as a whole. The non-standard measures have addressed the impediments to monetary policy transmission stemming from financial market dislocations and related threats to financial stability"

" Current challenges therefore do not call into question the primacy of the ECB's objective of price stability. On the contrary, it is precisely in this challenging environment that the benefits of price stability for Monetary Union as a whole will be reaped."

Jean-Claude Trichet (ECB President, France), 26 May

"As you know, in normal times central banks mainly influence the economy and inflation through the setting of short-term interest rates."

"In most recent months, with the overall recovery more firmly established, we have witnessed the emergence of upside risks to the medium-term outlook for price stability. Once more, strong increases in oil and other commodity prices have had a strong impact on headline inflation. Once more, we have to avoid commodity price increases becoming entrenched in longer-term inflation expectations, which could have second-round effects on wages and prices.

"We are carefully monitoring the situation and we stand ready to do whatever is necessary to fulfil our mandate - just as we have done over the past twelve and a half years."

"Let me emphasise that our non-standard measures do not in any way impinge on our capacity to tighten our monetary policy stance in response to inflationary pressures. There is a clear separation principle between our non-standard measures and our interest rate policy. Interest rate policy depends on the outlook for price stability. The use of non-standard measures depends on the functioning of the monetary policy transmission and must be commensurate with the level of malfunctioning or disruption of money and financial markets and segments of markets."