German Economic Growth Miracle is Not Miraculous Enough for an ECB Rate Hike

By: ECR_Research

The case for an interest rate increase by the ECB is building. Inflation in the euro zone is creeping up, and tensions in the Middle East are adding fuel to the ‘inflation fire’ by sending oil prices higher. The biggest worry of the ECB is that, although the inflationary effects of higher oil prices are mostly temporary, it will lead to a positive wage-price spiral in Europe’s biggest economy: Germany.

Summer of 2008

The similarities with the summer of 2008 are striking. Oil and other commodity prices were rising rapidly, unemployment in most of Europe was low and the risk of a wage-price spiral was increasing. The ECB then raised interest rates, despite the fact that most economists acknowledged that the risk of a severe worldwide slowdown was growing bigger as a result of the US credit crisis. However, the ECB has one - and one only - policy goal of an inflation level close but below 2%. 

With the benefit of hindsight, this rate increase was badly timed and unnecessary. A few months later, the ECB had to rush to lower interest rates toward an all time low for the Eurozone of 1%. 

Today, speculation that the ECB is mulling another rate increase is increasing, pushing up EUR/USD as a consequence. We at ECR, attach a less than 50% probability that the ECB will increase the policy rate in the coming quarters. Moreover, we think its highly unlikely that, if the central bank raises the interest rate once, this is necessarily the start of a series of rate increases.

The ECB must deal with the difficult task of setting one policy rate for different economies. The fast growing economies in the stronger ‘core’ countries – e.g. Germany and France - require a tighter monetary policy, whereas the weaker countries like Greece, Spain and Portugal need a much looser monetary policy to offset the negative effects of fiscal tightening.

Monetary policy ‘for the average’ more difficult

Some analysts have compared this with someone sticking his head in the oven, but his feet in the freezer. His average temperature is about right, but his physical condition is deteriorating rapidly. The fact that the economic and financial situation in the weaker Eurozone countries is deteriorating is well documented, as are the causes of this, and the structural solutions needed to increase their competitiveness in order to generate export income to service their ballooning debt service costs. 

However, we believe the prospects for the stronger core countries are also deteriorating, slowly but steadily. Consensus thinks differently and expects the positive effects of brisk German export growth to spill over to domestic consumption, igniting a new German growth engine, which will pull other Eurozone countries out of the doldrums. 

The reasons why we differ from consensus are as follows:

1. The high German growth rate over 2010 must be seen in perspective. In 2009, Germany was one of the countries most affected by the credit crisis and consequently plunged 4.7%. A growth rate of 3.6% in 2010 is a significant improvement indeed, but the economy still ‘needs’ a 1.29% growth this year to fully recover all output lost during the credit crisis.
2. The major part of German growth is still based on export growth. However, important export markets in Europe and China are all expected to slow down as a result of fiscal and monetary tightening respectively. It must be seen if German consumers are willing to pick up the baton by spending enough to compensate for slower growth in exports. Rising energy prices are not helpful in this regard, as they destroy consumer purchasing power and thus redirect spending towards energy.
3. Although the German growth rate will be reasonably high over the coming quarters, it will probably not be enough to pull the weaker euro zone countries along. Weak countries like Greece are facing an increasing difficult situation of negative growth, high interest rates and a pressing need to restructure government finances and gain competitiveness. All of these bring economic pain in the short term, lowering growth and tax revenues, increasing government deficits and frustrating efforts to bring down interest rates. These countries need substantial fiscal transfers from the stronger countries to sufficiently improve their solvency. Current programs as the EFSF are mainly designed to solve liquidity problems. However, the stronger countries are fiercely opposed to give ‘unlimited and unconditional’ financial assistance and are only willing to give liquidity assistance against interest rates, which are too high compared to their potential growth rates for the coming years. Ultimately, no one gains from this policy. Weaker countries will become weaker, limiting their ability to repay their loans in full to the stronger countries.  

Policy rate increase will aggravate Eurozone problems

To raise interest rates against this background appears suicidal for the Eurozone. First, already problematic debt service costs in the weaker countries will increase further. Furthermore, a tighter ECB policy reduces the supply of money. When money becomes relatively scarcer, the price of money – e.g. interest rates – are pushed upwards. As a result, banks - especially those in the weaker countries - will find it increasingly difficult (if not impossible) to attract sufficient liquidity against affordable rates.  

Second, a rate increase will not directly negate the inflationary force. The Fed’s monetary policy and growth in China are as important, if not more important, for commodity prices, as is the ECB’s monetary policy.

Third, there is no evidence yet that probably the ECB’s biggest concern and the most important reason to consider a rate increase are materializing, namely: that higher commodity prices are feeding into higher wages in Germany. On the other hand, deflationary forces are building in the weaker economies. Current inflation rates in these countries are surprisingly high, but that is mostly the result of higher VAT and commodity prices. However, these are initial effects; the secondary effects are deflationary, as higher VAT and commodity prices extract purchasing power of consumers, leaving them with less income to spend on other goods. 

As a consequence, it is doubtful whether the ECB will increase its policy rate in the near future. If the ECB indeed will not change its policy rate, the upward pressure on EUR/USD will likely be reversed. There are of course other factors at play, which could contribute to more downside pressure on EUR/USD. For example, speculation on a less loose monetary policy by the Fed (i.e. no QE III) and declining differentials between US en Eurozone interest rates. 

In case the ECB decides to raise the interest rate, in order to limit the risk of a positive wage-price spiral, then its very unlikely that it would be the start of a series of rate hikes. It will merely result in lower growth expectations once the rate hike impacts the weak countries. Then it is very likely that the summer of 2008 will be repeated, when the rate hike of the ECB just preceded a fall in economic activity.

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