The ECB case for a half-point rate hike just won't go away

NO matter how much European Central Bank (ECB) officials dismiss the prospect of starting interest-rate hikes with a half-point move this week, there's still a case for it.

Surging inflation, the euro's drop below parity with the dollar, and an impression that policymakers are behind the curve are just some reasons for a big increase on Thursday (Jul 21).

Among arguments against are the ECB's commitment to a quarter-point hike, the market's acceptance of that, a precarious growth outlook, and Italian political turmoil.

"It's true that they've communicated something else," said Martin Weder, an economist at Zuercher Kantonalbank in Zurich who says hope has persuaded him to make one of the only forecasts for a half point. "The signs are clearly pointing to a normalisation of interest rates - and the ECB hasn't even begun."

Weighing the threat of debt turmoil alongside the danger of losing control of inflation at a time of aggressive global tightening may be one of the ECB's trickiest judgments in years - not least as officials also negotiate a crisis tool to contain the fallout on Italy.

Only a small minority of policymakers has publicly argued for a half-point move, and most say a smaller hike is right to start off with. President Christine Lagarde has described a quarter point as an "intention" while cautioning a decision hasn't been taken.

Her Belgian colleague Pierre Wunsch, normally a hawk, called it a "done deal", and others have privately hinted that too. Almost all economists anticipate such an outcome, as do investors.

Here's a look at some arguments that may test that position as the Governing Council meets in Frankfurt.

Inflation

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Lagarde insists the ECB is "data dependent" - and the data keep going up. Inflation is at a record 8.6 per cent and climbing.

New European Commission forecasts show an average of double the 2 per cent goal next year. ECB projections suggest inflation will ultimately land above that target, and officials have already signalled a need to raise their outlook.  

Meanwhile slowing economic growth might not contain price pressures. A bigger hike now would remove some stimulus and allow for a pause if a recession then hits.

"The ECB has admitted that it has been consistently surprised by inflation," said Michael Schubert, an economist at Commerzbank in Frankfurt. "If they argue that they have to do more in case of upside risks, then that should also apply to the July meeting."

Against such reasoning, supporters of a quarter-point move can cite a decline in financial-market price expectations, and that euro-zone inflation is mainly supply-driven. They may also argue away a slight forecast overshoot as a margin of error and can warn a large rate move risks accelerating an economic slump.

Credibility

Most economists say the ECB is acting late, while trade unions in Germany, Europe's biggest economy, are seeking raises of 8 per cent and more - demands that suggest weak faith in the policy response.

A forceful move now might help policymakers convince financial markets, consumers and businesses of their commitment to fighting inflation.

ECB officials are also concerned that the credibility of their words should stand however. They have effectively promised a quarter-point rate hike, and they worry reneging on that could harm their ability to make believable commitments to investors in future.

Global tightening

By the end of next week, the US Federal Reserve may have raised rates by a total of 250 basis points. The ECB's reticence has prompted investors to sell the euro, pushing it to the lowest in 2 decades against the dollar.

A half-point move now might set a floor to the currency and stop its weakening from further stoking inflation.

ECB officials have shown only measured concern at the move however, and they emphasise that it's more a reflection of dollar strength. In trade-weighted terms, the euro has been more stable.

Turmoil risk

The ECB is concocting a crisis tool to contain market speculation that higher borrowing costs might make Italy's public finances unsustainable, a policy that itself should give the Governing Council room to raise rates.

While investors are anticipating a quarter-point move, other central banks have shown that a surprise bigger increase needn't cause alarm - as the Swiss National Bank did last month.

But a recent blowout of Italy's bond yields, the simmering political trouble there and the region's previous debt crisis provides a warning of the risks. A big move would threaten "excessive adjustments in market interest rates", chief economist Philip Lane said in June.

Seven weeks

Absent a big move now, it will be 7 weeks before the next scheduled opportunity to act, after the ECB's summer vacation. Any emergency meeting before then risks stoking panic.

Lane told colleagues at the June decision that deferring a larger move wouldn't make a material difference. That doesn't impress Weder at Zuercher Kantonalbank.

"What do you gain by waiting?" he said. "They're already behind the curve and will fall behind even further by waiting 2 more months." BLOOMBERG