• Revision. We are raising our ECB forecast and now expect three further minihikes, bringing the refi rate to 4.50% by the end of this year. Reasons for this are rising inflation risks driven by still very high money and credit growth, high wage increases as well as a rosy EMU growth outlook. A rapid decline in unemployment and brisk investment activity will bring GDP growth back to above potential after a brief dip in Q1 2007.
• Exchange rates. A more aggressive ECB will mean support for the EUR and keep EUR-USD in the 1.30-1.35 range longer than predicted so far. Indeed, a test of the high for the cycle so far at 1.3667 is quite possible until mid-year. Once, however, the Fed rate cut expectations are priced out, EUR-USD will fall back and reach the 1.30 mark again at the turn of this year.
• Interest rates. EMU's yield curve will remain flat or even slightly inverse also in the second half of 2007. Yields at the longer end are rising hand in hand with money market rates. The 10Y Bund yield should rise to close to 4??% by the end of 2007, following broadly the trend of its US counterpart.
• Fed. We are also revising our US inflation forecast and no longer expect a pronounced pullback in the core rate. The Fed??™s implied inflation target of 2% will not be reached before the end of 2008. This is a further reason why we ??“ unlike the markets ??“ do not expect the Fed to ease this year.

Further topics:

• Weekly Comment: Bernanke ??“ is it clear now?.
• Data outlook: EMU purchasing managers to remain confident; their US colleagues, in contrast, are becoming slightly more cautious.
• Market outlook: Bonds under pressure, EUR well supported.

BERNANKE: IS IT CLEAR NOW?

Last week we noted how Bernanke??™s push for a more transparent FOMC statement had paradoxically thrown the markets into a state of confusion. But Bernanke is a top-notch professor, and faithful to the academic notion that repetita iuvant, he reiterated the message in his testimony to Congress last Wednesday. His analysis vindicates our initial reaction to the FOMC statement: faced with heightened uncertainty on the macro outlook, the Fed has reclaimed additional flexibility to tailor its policy response to future developments. In this regard, Bernanke indicated very clearly that explicit guidance on future rate moves is only warranted in exceptional circumstances (the long and gradual normalization which came to an end under his watch). It makes a whole lot of sense when you think about it. In normal conditions, if you think the level of interest rates is not appropriate, you should change it now. If you think it is appropriate, the best you can do is highlight the balance of risks, and monitor developments as they unfold.

And it is the balance of risks that holds the key to the Fed??™s stance and future policy moves. Bernanke acknowledged the higher uncertainty surrounding the growth outlook, and was careful to point out that there are both downside and upside risks to the Fed??™s baseline growth scenario. Risks to inflation, on the other hand, were seen as squarely to the upside. Bernanke acknowledged very explicitly the subprime issue, and his analysis was very linear: (1) it is a serious problem, with adverse social consequences; (2) there is no evidence so far that it will spill over to the broader housing market and trigger a contraction of credit and consumption; (3) however, of course such a risk scenario cannot be ruled out and the situation must therefore be monitored closely.

Inflation, on the other hand, is not just a risk but a present problem: inflation rates remain elevated, and in particular, ???the level of core inflation remains uncomfortably high???, and ???core inflation is above the levels most conducive to the achievement of sustainable growth and price stability.??? Again the message was very clear: we believe inflation is set to moderate, but it is still too high and we see risks that it will remain so. Bernanke also emphasized the importance of keeping inflation expectations under control. There is a lively and increasingly open debate as to whether the Fed should try to push inflation below 2% or not, depending also on what the output costs of the extra disinflationary push are likely to be. Whatever the outcome of this debate, it appears very clear by now that the Fed is more than willing to accept a growth rate as low as around 2% to make sure inflation remains under control and give the economy time to work off its main imbalances. This has two main implications:

1. No rate cuts: as long as the soft-landing scenario plays out, the Fed will stay on the sidelines. It would take a substantial further deterioration in growth to induce it to cut rates.
2. No Bernanke put: even significant corrections in asset prices will not trigger a monetary response, unless of course they are so dramatic as to threaten a recession. Bernanke will not replace a bubble with another, given the risk that the latter might be a straightforward inflation bubble.

The market took some notice on Wednesday, and in time we believe the expectations of Fed rate cuts will be priced out. It is against this background that we have just revised our ECB call. The data continue to support our bullish view on the euro-zone economy, with capital expenditures and the labor market set to fuel growth for the remainder of the year and into 2008. Unemployment has dropped markedly, and rate hikes so far have done little to slow down the growth of money and credit aggregates, with the only exceptions of M1 and household mortgages. With a soft landing in the US and buoyant growth in key emerging markets, all the conditions are in place for the ECB to keep hiking, and we now expect the refi rate to reach a peak of 4.50% by the end of the year.