Friday, April 29, 2011

More ECB rate hikes needed

I have long been of the opinion that the ECB will start to raise rates early (see A higher ECB repo rate by June dated Feb 2) but leave liquidity ample and that this would not constitute a policy mistake (see No ECB policy mistake dated April 5) as the North-Eastern countries need higher rates whereas the ECB repo rate has lost in importance for the fiscally challenged and economically underperforming peripheral countries.
The latest economic data - be it real activity, inflation or monetary data - all support the case for further significant rate hikes to 2-2.25% by year end (which means the ECB will likely take a 50bp step, probably in Q4). Today's 2.8% estimate for yoy CPI in April marks the highest inflation rate in the ECB's history, barring the end 2007-end 2008 period when, however, the repo rate stood at 4% (and was raised to 4.25% in the summer 2008) and just before the deflationary impact of the Great Recession depressed inflation rates again. Now the repo rate stands at only 1.25% and given the surging inflation rates has increasingly accommodative effects on the already strongly growing North-Eastern countries, most notably Germany. And to reiterate: For the economically weak peripheral countries the level of the repo rate has lost in importance as bond yields have become much more dependent on credit developments (Spain, Italy, Belgium) or are a matter of negotiations with the EU/IMF (for Greece, Ireland, Portugal). Additionally, for the banking sectors in these countries it remains more important to secure funding than the price they pay for this funding and here the ECB still provides ample liquidity.
Furthermore, today's M3 data - where yoy growth came in at 2.3% - only look low at first sight. I have long been of the opinion that looking at M3 does not provide an accurate picture about the state of the economy/future inflation risks. Given that M1 constitutes roughly half of M3, and M1 is extremely influenced by the ECB's balance sheet developments, M3 is very dependent on the ECB's measures as well. When the ECB significantly lengthened its balance sheet in 2008 to support the financial system, it also helped to stabilise M3. However, the related growth in M3 was not a precursor of inflation. Now that the ECB stopped growing its balance sheet, M3 growth is being depressed. In turn, M3 growth remains distorted and does not provide accurate signals about future inflation pressures.
ECB Balance Sheet (in €mln)
Source: Bloomberg

I think that a much better indicator of inflation pressures than M3 growth is growth in M3-M1. M3-M1 is not distorted by the ECB's balance sheets actions and much better reflects supply and demand for funds in the banking sector and the real economy. The chart below shows yoy growth in M3-M1 compared to growth in M3. It highlights that in 2008 inflationary dangers were unprecedented (whereas according to M3 they were similar to late 2001), in 2009 deflationary pressures were larger than M3 data indicated and that by now inflationary pressures are similar to late 2005. Yoy growth in M3 of 2.3% is still the lowest in the history of the Euro, barring the period since the Great Recession. In turn, M3 data would suggest that inflationary pressures remain very low, whereas M3-M1 data shows that inflationary pressures have risen significantly.
M3-M1 does not track M3 all the time
Source: ECB, ResearchAhead

Finally, growth in M3-M1 fits well with headline inflation and has a good fit with the ECB repo rate (in fact a much better fit than M3 data). The chart below compares yoy growth in M3-M1 with the ECB repo rate as well as with yoy headline CPI. As can be seen, growth in M3-M1 tracks the ECB repo rate well, especially since around 2002. It explains why the ECB waited so long in 2005 to hike rates (whereas growth in M3 would have suggested a much earlier rate hike) and again why it chose to hike rates at the start of this month despite low M3 growth data.
Growth in M3-M1 tracks the ECB repo rate well
Source: ECB, Bloomberg, ResearchAhead

Overall, activity, inflation as well as monetary data all suggest the need for a significantly higher ECB repo rate. If history is any guide, the current environment would be compatible with a repo rate of at least 2%! I expect the ECB to take us there by year-end (and to hike further in 2012).

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