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ECB Watch: Are the markets reading Trichet right?

For 11 months the European Central Bank has been engaged in a gradual tightening of monetary policy or, to use the more nuanced language of ECB president Jean-Claude Trichet, a “progressive withdrawal of monetary accommodation”. The financial markets and commentators have learnt to read quite accurately the code words – such as “strong vigilance”, “vigilance”, “continuing to monitor closely” – used by the ECB to signal what its next move is likely to be.

In consequence, as pointed out in this column last month, markets have been able to anticipate the ECB’s decisions from month to month without being seriously wrong-footed. What is less clear, however, is whether or not the markets are correctly interpreting the indications that Trichet has been giving as to the likely course of monetary policy over horizons longer than one or two months ahead.

In principle, the ECB’s policy stance for the medium term is clear enough. In Trichet’s words to successive monthly press conferences, interest rates are “still low in both nominal and real terms”, liquidity remains “ample by all plausible measures” and monetary policy “continues to be accommodative”. Hence, “if the governing council’s assumptions and baseline scenario” for the eurozone economy – currently characterized by the ECB staff’s September macroeconomic projections for 2006 and 2007 – “continue to be confirmed, a progressive withdrawal of monetary accommodation will remain warranted”. Since the staff are now projecting the headline inflation rate to be stuck at 2.4% this year and next, and GDP growth to slow only slightly from 2.5% in 2006 to 2.1% in 2007 (all revised upwards, see chart), this would suggest that the governing council envisages continuing with its policy of raising interest rates in small steps well into 2007.