ECB Set to Hold Rates, Pull Trigger in July

The European Central Bank looks set to keep its benchmark interest rate stable at 1.25 percent at its June 9 meeting, analysts told Policymakers will remain "strongly vigilant" on inflation and global growth concerns, as well as on any potential further rounds of quantitative easing in the US, meaning that a rate rise in July looks likely.

European Central Bank
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European Central Bank

The ECB is generally more sensitive to headline inflation than other major central banks, analysts said, and will continue to watch risks to the consumer price index (CPI), despite the deflationary effects of a slowing global economy.

Analysts will be watching the code words typically used by the ECB to hint at future rate rises. In May, many were waiting for the words "strongly vigilant', which would have indicated a rate rise in June. They will be waiting for the same phrase on Thursday.

"I do not expect a rate change at the meeting because Mr Trichet has destroyed all expectations of a rate hike in the June meeting at the last press conference," Michael Schubert, senior economist at Commerzbank, told "Nevertheless, he will signal the rate hike by emphasising that the ECB is 'strongly vigilant'. This is the key code word to say that if nothing exceptional happens they will raise rates at the next meeting.

"They see the risk of inflation is rising… therefore they see the need to proceed with monetary policy normalisation, to prevent expectations of higher inflation from becoming entrenched," Schubert said.

Signs that Europe's recovery is continuing its recovery well, despite softer data from the US calling into question the pace of the global rebound, could also justify a further hike, Schubert added.

"(The ECB) are still in this code-wording world. I think it's likely that they will use it, thought they've seen some slowdown in economic indicators. It still looks like the overall average economy is going at a pretty decent pace and inflation is still pretty high, and we still have real interest rates well in negative territory. Therefore the interest rate increase in July seems to be a done deal," Juergen Michels, Citi's lead economist for the eurozone told

"All this talk of Greece is likely to have very, very little impact on their position."

After taking a number of extraordinary measures to improve financial stability in Europe, the ECB is keen to demonstrate that it maintains its focus on managing inflation, Michels added.

Michels believes that, after a 25 basis point hike in July, the next rise will be in October.

Balancing deflation risks with the threat of consumer price inflation is key to the ECB's decision making process, Carl Weinberg, chief economist of High Frequency Economics wrote in a research note. However, unlike the Bank of England, the ECB does not seem able to look through short-term volatility in prices, he said.

"The ECB has not yet reached that level of analysis," Weinberg wrote. "Despite the fact that two member governments are on the verge of collapse, the uber inflation hawks in Frankfurt are having a hard time distilling anything from the tea leaves besides the argument that inflation risks are imminent."

The ECB should see the risks to the banking system of a sovereign default as a potential source of deflation, should banks cease lending or collapse, Weinberg said.

"Oil prices can rise to a gazillion dollars per barrel – never mind that they are actually falling right now – but that will not translate into higher prices in the CPI if all banks in Euroland stop writing new credit and/or fall. As we saw in 2008-09, a banking sector-driven credit crunch kills demand and jobs almost instantly, and no one will be able to pass through price increases to consumers if those circumstances recur," he wrote.

Some observers have taken watching the ECB's code words too far, Astrid Schilo, European economist at HSBC, told Jean-Claude Trichet's press conferences have become more about the president's vocabulary than about the bank's views on the eurozone economies.

"In 2005-2006, when you had 'monitor very closely' as opposed to 'monitor closely', it meant that you would have 'strongly vigilant' a month after. But of course we didn't have 'strongly vigilant' in May," she said.

"So you have to be careful not to get bogged down too much by the keywords, but I think something like 'we are strongly vigilant' still signals that the ECB intends to raise rates at the next meeting."

Citi's Michel agrees. "I think they went a bit too far with this whole concept, and there may be a point where they want to get away from it," he said.

"There may be a point where they do not deliver this sort of traffic light system, which starts with monitor closely … They want to give some guidance to markets, but it's really the 'strong vigilance' that is the market mover, not the rate hike itself. That leads to some weird things."

The code words are more hints as to the timing of rate changes than indicators of changes to overall policy, he said.

"If you just have these code words, everybody is just looking for the code words and almost forgetting the rest of the press statement. I think in this way they may not be pleased by the whole signalling procedure, because it's likely to lead to some oversimplification of their message."

HSBC's Schilo is predicting that a rate rise of 25 basis points in July will be followed by another in the winter.

"We have rates at by 1.75 by the end of the year, and we are expecting (a second rise) around November. What we've said is we have that hike in July, then we go through the cycle which is a hike every four months," she said.

Schilo noted that the ECB has alluded to the possibility of more money being injected into the US economy by the Federal Reserve.

"They don't really say it openly, but there are also references to abundant global liquidity in the ECB statement. We know where this comes from."

How that actually affects the ECB's future decisions remains to be seen, Schilo said.

"It could be that (quantitative easing) just creates more commodity price inflation from loose monetary policy conditions in Asia, for example. So basically what you're doing is stimulating parts of the world economy that may not be your primary goal for stimulation, if you're on the Fed board," she said.

"In that case, if you get another round of high headline inflation… I think there would be the risk that the ECB would speed up the tightening cycle."