ECB Watch: Does normalization imply a ‘refi’ rate of 4% next year?


John Arrowsmith
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The ECB sets great store by the transparency of its decision-making process and the clarity of its communication with the outside world. ECB president Jean-Claude Trichet was reminding us of this again last month.

Faced with a mixed bag of evidence about recent economic developments, the European Central Bank left its key interest rates unchanged in April, in the wake of the 25 basis point increase in its main refinancing rate, to 2.5%, in March. GDP growth in the final quarter of 2005 was confirmed at 0.3%, down on the third quarter’s 0.6%, and the various monthly indicators of activity showed at best lacklustre growth at the beginning of 2006. However, survey-based data were pointing to buoyant confidence and economic sentiment, headline inflation was remaining stubbornly above 2%, there were signs of a feed-through from high oil prices and those of other commodities along the domestic price chain, and money and credit growth continued to balloon.

It is against this background that the ECB has been preparing financial markets for another rate rise in June, with a hint of further increases in the months ahead. At his regular press conference following the governing council’s April 6 meeting, ECB president Jean-Claude Trichet pointed out that interest rates were still very low and that monetary policy remained “accommodative”. He warned that, with risks to price stability continuing on the upside, the ECB was in a “process of normalization” to prevent those risks from materializing, which was why it had raised rates twice already and why there would be an increase in the future. Most tellingly, he added that the financial markets had been misguided in pricing in a rise for May and mistaken if they believed that the governing council would never change rates when it was meeting outside Frankfurt, as it will be in June (in Madrid). This is the most explicit guidance he has given to markets since his indication last November that rates would go up in December.

Trichet stopped short of saying how large the June rise would be or whether it would mark the end of the normalization process but the likelihood is that next month there will be another 25bp rise, to 2.75%, with two or three further increases, to 3.5% or 3.75%, over the following 12 months. He and fellow governing council members refuse to be drawn on what they might have at the back of their minds as the neutral, or “natural”, rate of interest – by which economists mean the real rate of interest that is consistent with both a stable inflation rate and actual output in line with potential output – because, although this is a valuable theoretical concept, empirical estimation of what its level is at any given time is fraught with difficulties. Even so, this has not stopped the ECB’s own staff from trying to get some sort of a handle on it, with their latest published research suggesting a current ballpark figure for the neutral real short-term rate of rather less than 2%. If we take this together with the ECB’s policy objective of inflation “below but close to 2%”, we arrive at a notional 3.75% to 4% as the (ballpark) neutral rate in nominal terms.

Whether the ECB would regard this as the point at which monetary policy ceases to be accommodative and whether there will be a need for rates to overshoot this level and monetary policy become restrictive later next year remain open questions. The answer, for the pragmatic governing council, will depend on practical policy considerations such as oil price movements (and their feed-through and possible second-round effects on inflation), the rate of economic growth and monetary developments, between now and then.

Growth of M3 and Bank Loans to Private Sector
Source: Eurozone Advisors

John Arrowsmith is a senior partner of Eurozone Advisors, an independent research company.


He was formerly senior adviser on western European and EU affairs at the Bank of England, played a key role in drafting the Maastricht Treaty and advised the UK Treasury and Foreign Office on the policies of the European Central Bank.