The European Central Bank: More hikes before pause

Although this Fed interpretation view may discourage being too bearish the U.S. dollar over the medium term, the next few months is a different story. The ECB is likely to raise interest rates in both March and the second quarter, which will likely continue to support the euro even though these hikes have largely been discounted.

With the region’s price pressures moderating because of declining energy prices, the ECB may be content that, with its refinance rate near 4 percent by mid-year, it has normalized monetary conditions. The euro may be especially sensitive to how the ECB signals its intention to pause. The Federal Reserve arguably has encountered some challenges in convincing the market that a pause, even if protracted, is not the same thing as the end of the cycle. The transparency and predictability the market has come to expect from the ECB may be more difficult to sustain as policy reaches neutrality.

Outside of Germany there has been a lack of significant structural reforms in the Eurozone. Particularly, low productivity — despite a cyclical upturn — undermines longer-term confidence. It is difficult to envision the Eurozone’s economy sustaining growth much above 2 percent.

Workers in Germany’s engineering and chemical sectors may get wage hikes in excess of 3 percent, with labor action a distinct possibility in the former area. However, other parts of the economy, including the public sector, retail, and construction will be hard pressed to strike the same kind of deals.

In other parts of the Eurozone, such as Spain, Portugal, and Italy, wage agreements are likely to be in excess of productivity gains. After all, Spain and Portugal experienced an outright decline in productivity growth in 2006 (-0.5 percent and - .3 percent, respectively), and Italian productivity rose a negligible 0.1 percent. This hints at a loss of competitiveness on the periphery of the Eurozone, something that can be overlooked when looking at aggregate figures.

European growth remains export-driven, and this “borrowing” from the world’s growth has been a critical part of the region’s economic recovery. Consider that in 2000, German exports were 33 percent of GDP and by last year had increased to more than 40 percent. Austria, Belgium, the Netherlands, and Ireland exported more than 50 percent of their GDP.

Another year of strong world growth bodes well for the region and the ECB is more likely to lift rates above 4 percent rather than peak below.