ECB hikes ahead

The U.S. Federal Reserve left the fed funds rate steady at 5.25 percent at its Aug. 8 meeting. Speculation is rampant within the marketplace on whether that will represent the peak for this tightening cycle or whether additional hikes may occur later in the year. The Fed meets next on Sept. 20.

The uncertainty surrounding the U.S. monetary policy outlook is in stark contrast to the current market view on the ECB. The European central bank hiked rates by 25 basis points on Aug. 3, lifting the overnight cash rate to 3 percent.

It left rates unchanged at its Aug. 31 meeting. Given the latest growth and inflation forecasts, market watchers firmly expect another two rate increases this year, most likely 25 basis-point moves at the Oct. 5 and Dec. 7 meetings.

David Powell, senior currency strategist at Ideaglobal in New York, calls a 3.5-percent rate in Europe by year-end “entirely priced in” by the currency market.

Overall, analysts say the narrowing yield spread between U.S. and European rates will be modestly supportive to the euro.

“The ECB is proceeding on the path to normalization, bringing borrowing costs to a point where they are neither adding to nor subtracting from economic growth,” Guest says. “This follows a long period of highly accommodative borrowing costs, when real interest rates were in fact negative in many Eurozone countries.”

Money supply growth figures will keep the ECB on a hiking path into early 2007. The Eurozone figure was 8.5 percent year-over-year in June, while the three-month moving average (which the ECB uses for its policy decisions) was 8.7 percent year-over-year.

Powell says this compares to the ECB’s reference rate of 4.5 percent.

“Money supply and credit growth remain very high,” Powell explains.

Euro area inflation fell to 2.4 percent in July, a slight reduction from the heading rate of 2.5 percent in June.