The European Central Bank (ECB) is in no hurry to ease monetary policy further despite inflation for...
The European Central Bank (ECB) is in no hurry to ease monetary policy further despite inflation forecasts remaining below its official 2% target.
Merrill Lynch global asset allocation strategist CÃ©sar Molinas says the ECB's projections released in June show a mid-range inflation forecast for 2004 of 1.3%. However, the bank is not expected to react to the numbers as quickly as other inflation-targeting policymakers.
'We believe the ECB is likely to react to inflation forecasts being substantially below 2% with the same flexibility it has reacted in the past to inflation being substantially above 2%,' he says.
As evidence of the bank's wait-and-see attitude, Molinas cites the cancellation of its governing council meeting, scheduled for 21 August, allegedly because of a lack of topics to discuss.
In addition, ECB chief Wim Duisenberg has announced he will be absent from the next interest rate setting meeting on 4 September because he will be fishing in Canada. This relaxed attitude seems to be widespread among ECB officials, says Molinas.
However, there are a number of risk factors that could spur short-term action. First, the recovery in the US may stall again or, more likely, show less strength than currently anticipated.
Molinas says this may halt the improvement in the eurozone's business and consumer confidence, especially if it takes place before this improvement in confidence results in stronger economic activity. A correction in the equity market rally, further strength in the euro or even a continuation of the untimely sell-off in the bond market leading to prematurely tighter monetary conditions could all prompt a rate cut. he adds.
On all the risk factors the ECB is considering, Merrill Lynch has strong views. Molinas notes: 'We remain cautious about the sustainability of a strong recovery in the US, we continue to believe the ongoing equity rally is a bear market rally. We continue to anticipate a much weaker US dollar in 2004 and we feel there are strong risks of higher long-term yields, especially in the US.
'Accordingly, we continue to believe the ECB will be compelled to cut rates. Its current wait-and-see stance may be prolonged but the materialisation of one or several risk scenarios should prompt it to cut rates to 1.5% in the first quarter of 2004. We believe the risks to this call are in the direction of getting a cut in December 2003.'
Peter Oppenheimer, bond strategist at Goldman Sachs, forecasts another 50 basis point cut by the ECB but says global developments have made this less likely. 'Given the cumulative evidence pointing to a pick-up in economic activity, there is not much scope for long-term yields to fall but, equally, low short rates will limit the potential for yields to rise from here,' he says.
The fundamentals for credit are still improving in both the US and Europe, Oppenheimer says, citing the 63% of companies that reported higher earnings for the second quarter of 2003 than a year ago, with debt ratios projected to fall further.
'Nonetheless, there are some clouds on the horizon,' he notes. 'As government bond yields have backed up, the potential for spread pick-up from going into credit has shrunk on a percentage basis, making the move from government bonds into credit less compelling.'
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