NEWS / Foreign Exchange

ECB: Strict policy would better fit ECB view

• The ECB hits a ???neutral??? interest rate, when it most likely raises its policy rate to 4.0% in June. Judging from various rules of thumb, a ???fair??? rate in the current economic situation may not be as high as 4.0%. However, given ECB interpretation of the economic situation and ECB rhetoric the ECB may feel more comfortable with a slightly tight stance rather than a neutral stance.
• There are only feeble signs that the VAT hike in Germany has had any effect on underlying dynamics. We have been surprised that business confidence has remained stable and that hiring is still strong following the plunge in retail sales at the beginning of the year. Thus, while German GDP growth is likely to be modest or stall in Q1, we are looking for above-trend growth again in Q2.
• In addition, we see support to the Euroland economy from the turnaround in the global industrial cycle, which is already brewing in the USA and Asia. While a tighter policy will dampen Euroland growth, the net result is thus likely to be growth just above trend in H2-2007 and into 2008. This will keep unemployment falling and the ECB on guard to neutralise potential higher wage growth.
• While we believe that there are good reasons to be very cautious about raising rates further, the ECB will probably feel tempted to raise rates further given the fact that they forecast growth above trend, inflation just above the target, and that they continue to see inflation risks on the upside. We therefore adjust upward our target for the ECB to end 2007 at 4.25%. We believe the ECB will raise rates to 4.25% by September, although the rise could also appear later, as the ECB turns more cautious and even data dependent.