Friday, June 24, 2011

Will someone please explain to me why the ECB is hiking in July

I've gotta say, I have absolutely no idea why the ECB is hiking. If I look at key monetary variables (forget about the real economic data for a minute), they should be on hold.

(1) inflation expectations has dropped off precipitously across key countries in Europe, as measured by the 10-yr swap linker. One could argue that it's simply market sentiment and oil - which could very well bounce back - but the same measure of US inflation expectations is sticky at 2.7%. Chart 1 below.

2) key monetary variables, the annual growth in the money supply (M3) and lending to euro area residents have tapered off at levels not seen since 2003, with exception to recent history. On a 3-month annualized basis, growth rates have slowed markedly from peak levels earlier in Q1 2011 (MFI loans) and Q3 2010 (M3 growth). Charts 2 and 3 below.

(3) A cursory view of the history of ECB rate targets, US Fed rate targets, and the monetary variables suggests a high correlation between US Federal Reserve policy and Euro area monetary variables. In fact, on a 3-month annualized basis, MFI lending to Euro area residents has a 70% correlation to US Fed policy, a much greater correlation than with ECB policy (50%) - this same correlation is more balanced at the % Y/Y level. Chart 3 below.

(4) The money supply has a high correlation to ECB policy using either the Y/Y or the 3-month annualized growth measures. Money supply is a lagging indicator (one of the lengthier lagging indicators) - I would go so far as to deduce that this high correlation is further indication that the ECB is a 'reactive' bank.

It's going to be very tough for the ECB to eke out another 25 bps, let alone 50 bps by year end (the market is pricing in roughly 40 bps of hikes by year end). The economic (not this article) plus monetary data don't even support it.

Accompanying Charts

Rebecca Wilder


  1. another question to ask would be who benefits from a rate hike...

  2. I don't know anything about the ECB.  But rates can be a head fake (Keynes's liquidity preference curve is a false doctrine). 

    You have to watch money flows & you have to use the correct lags.  Since the ECB restricts reserves to IBDDs that ought to be easy.

  3. Patrick VB, Brussels BelgiumJune 25, 2011 at 5:17 AM

    <span>There are two other elements to be considered here. First, the ECB is looking at unemployment rates in the euro area. As Germany is the biggest EA country, the evolution of unemployment there (and in France) could lead to the upward drift in policy rates. Second, the ECB could be raising rates as a political play in the context of the euro area debt crisis. Any rate increase threatens the (short-term) viability of the current "kick the can down the road" strategy of the European Council and Commission. Higher rates could force them to adopt longer-term and (more) coherent solutions to the current debt problems.

  4. Hi Patrick,

    I agree about the unemployment rate; but the ECB targets inflation. If you estimate a Taylor Rule for the ECB (using Euribor, inflation expectations, and the output gap), you'll find that the inflation expectations dominates the regression. It's all about inflation for them, which is why I am so perplexed by their continued hawkish rhetoric despite the fact that commodity and oil prices have peaked.

    "<span><span>Second, the ECB could be raising rates as a political play in the context of the euro area debt crisis." </span></span>The fact that the ECB is effectively using monetary policy to push national interests down the path of fiscal union - as you highlight, is one of the only reasons that I can see as to why they're hiking now - highlights the inherent structural deficiencies of the monetary union without fiscal union. I can only assume that if there was some sort of Euro area "Treasury Secretary" pushing tighter fiscal policy, the ECB would be on hold for much longer.

    This is very very dangerous.


  5. I'm less concerned as to whether or not they will be successful in hiking rates, more concerned with the rationale for taking back liquidity. Check out table 2 of this ECB paper: all of the weaker economies are financed primarily by variable rate mortgages (spain for example is 91%). Only Finalnd is considered a core economy where rate hikes will be very effective, given the 96% variable mortgage rate. This is going to bite back.

    What lags do you suggest? I didn't make them explicit in my charts above, however, they are evident.


  6. Hey rjs,

    As I highlight above, the weaker economies benefitted from the rate reductions and will be more so overwhelmed by the rate hikes, given the high share of variable mortgages.

    Besides, if they're targeting macro policy essentially at Germany - not that their economy is truly going gangbusters or anything like that - how is an interest rate policy effective at all? Germany exports a bunch of stuff - interest rates can only affect that economy on the margin, at best. That's why other really open economies, like Singapore, target an exchange rate rather than the domestic economy.

    My point is, it would take an inordinate amount of rate hikes for this blunt tool to successfully slow down Germany's export base.


  7. Perhaps the BIS have something to do with it. Their view seems to suggest that there is a serious possibility of higher inflationary expectations becoming locked into the system, an erosion of central banks' credibility and therefore  BIS is/are encouraging central bankers to do "too much too soon" about inflation rather than "too little too late"?

  8. this is where ive become more cynical than you are, rebecca; i dont see the central banksters as acting on behalf of their economies or the people affected by them except insofar as it benefits the banks and the elite rentier class that they protect and serve...most times, their interests mesh, so we tend to harbor the illusion that central banks are always going to be our beneficiaries...

  9. Patrick Van BrusselenJune 27, 2011 at 9:06 AM

    Hi Rebecca, As you say, the ECB's official madate is to target HICP headline inflation (no double mandate). Notwithstanding the official mandate, the ECB does look at wage cost developments (Trichet's famous second round effects) to make their policy calls. In this regard, the declining unemployment rates in Germany and France could be cause for worry for the ECB, even though low unemployment rates in these two countries have not (yet?) led to higher wage costs.