September 20, 2007
With the euro today having finally breached the mark of $1.40 and the Fed having cut its interest rate by 50 basis points, it is now clear that the interest rate hike originally planned by the ECB for September will not be made up for quickly. Instead, there might not be another hike for a long time now.
Until very recently, ECB officials had still publicly insisted that their interest rate hike was merely postponed, but not cancelled. With the changes of the economic environment over the past weeks, there is now little argument left for a rate hike and their is little indication that this will change quickly.
First, there is the euro: With now trading a little above $1.40, it will dampen both export growth and lower inflation as it makes imports cheaper and exports dearer. The Fed’s rate cut has lowered the gap between short-term yields in EMU and the US, a process which might put further downward pressure on the dollar. The ECB cannot have any interest to accelerate this process, especially given that the French president Nicolas Sarkozy will not leave out any opportunity to bark at the ECB should the euro appreciate sharply. Any ECB rate increase now risks setting in motion a further fall in the dollar with a siginficant risk of overshooting.
Second, with the three-months-money-market interest rate now being systematically – and for several weeks – about 70 basis points above the main refinancing rate, the banks in Europe are already confronted with monetary conditions equivalent to those after two more rate hikes. So far, we have very little indication how that feeds into credit conditions, but it is very safe to assume that a more expensive money supply will also lead to more expensive company and household loans, which in turn will again dampen growth in the euro area.
As the ECB knows all this and has – despite its and Mr Sarkozy’s rethorics – run a very prudent and carefully balanced monetary policy over the past years, it will most likely refrain from any interest rate hikes anytime soon. Seems as if the 4 percent are here to stay for a while.