INFOCUS. When might the ECB raise interest rates? MARKET SNAPSHOT JULY 2017

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INFOCUS MARKET SNAPSHOT JULY 2017 When might the ECB raise interest rates? DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. The icons alongside represent our investment process.

1 INFOCUS MARKET SNAPSHOT JULY 2017 When might the ECB raise interest rates? DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. The icons alongside represent our investment process. Through a disciplined provision of investment policy and security selection at the global level, regional portfolio management teams have the flexiblility to construct portfolios to meet the specific requirements of our clients. HIGHLIGHTED IN THIS PUBLICATION: GLOBAL STRATEGIC ASSET ALLOCATION REGIONAL ASSET ALLOCATION GLOBAL SECURITY SELECTION REGIONAL PORTFOLIO CONSTRUCTION

2 Ahead of the next ECB Monetary Policy Meeting on 20 July, EFG s chief economist, Stefan Gerlach analyses the case for a rise in interest rates and considers when such a rise might take place. While the economic recovery in the euro area is continuing, it is too early to expect the European Central bank (ECB) to raise interest rates. But under what conditions might it do so? This note looks at the drivers of ECB interest rate decisions, using monthly data over the period It draws two main conclusions: The ECB responds strongly to changes in the state of the business cycle and, in particular, to the outlook for prices. While the statistical analysis suggests that the likelihood of an interest rate increase currently is about 6%, a combination of stronger growth and higher price pressures could quickly raise that probability to about 30%. (Past interest rate increases by the ECB have on average been associated with the model predicting a 30% probability of an increase.) Following the onset of the financial crisis in 2008, the ECB s interest rate setting behaviour changed as it became less likely to raise interest rates and more likely to cut them, given economic conditions. Had its behaviour not changed, the likelihood of an interest rate increase today would be about 22%. Thus, a return to ECB s precrisis behaviour would lead to a dramatic increase in the likelihood of a hike in interest rates. 1. Modelling central bank interest rate setting A large body of analysis shows that the main factors impacting central banks interest rate decisions are inflation and the state of the business cycle. The business cycle matters either because, as the Phillips curve suggests, it is a determinant of inflation, or because stabilising the economy around its growth path is an independent goal of monetary policy. To study their role for ECB s interest rate setting, the state of the business cycle and the rate of inflation must be measured. While this is simple in theory, it is difficult in practice for several reasons. Economic time series often display large swings that central banks disregard in setting policy. For instance, temporary falls in economic activity due to severe weather or industrial disputes, or changes in inflation due to increases in VAT, are cases in point. Data are missing on key variables which therefore must be estimated. For instance, measuring the business cycle by the output gap requires an estimate of potential output. Measuring it by the difference between the unemployment rate and the NAIRU requires an estimate of the latter. And data on underlying inflation must also be constructed or estimated. Since monetary policy impacts on the economy with long lags, in setting policy central banks rely on internal short-run forecasts to which policy judgement is added. It is therefore often unclear what policymakers outlook for the economy was at a point in time. The variables policymakers focus on can change over time and may differ between policymakers. In Figure 1 we use the euro area PMI, which is a good indicator of real GDP growth over four quarters, to capture the ECB s assessment of the state of the business cycle. Furthermore, we use the PMI for manufacturing input prices, which contains information useful for forecasting future HICP inflation, to capture the ECB s views of inflation pressures. While these are soft indicators of economic conditions, they summarise the state of the economy better than hard data since they are available much more rapidly, are less sensitive to a host of data problems 1 and they are inherently forward-looking. They are therefore likely to be strongly correlated with the ECB s views of economic conditions that are the starting point for its policy decisions. Figure 1 shows that the PMI captures the weakness of economic activity following the dot com bubble bursting 1 Such data problems can arise from, for instance, poor depersonalisation, faulty working day adjustment, measurement errors and changes in weighting schemes. 2 Infocus July 2017

3 in 2001, the collapse of Lehman in 2008 and the sovereign debt crisis that started in The PMI for input prices shows the rise in inflation pressures in 2008 and While both spikes were driven by oil prices, they led the ECB to tighten monetary policy. Interestingly, the high and positive correlation between the two series, 0.60, suggests that swings in the demand for goods and services were the main driver of the euro area economy over the period in question. 1. Euro area Purchasing Managers Index (PMI) Index PMI Source: Markit Input 2. A simple statistical model To explore what information about ECB interest rate setting these variables contain, they are included in a simple statistical model 2 of the ECB s policy decision to cut, leave unchanged or raise interest rates, over the period February 1999 May The model is estimated on data only for the months at which the Governing Council, the ECB s decisionmaking body, met to set monetary policy. The model includes the following variables: The lagged refinancing rate. If the interest rate reverts to some normal or average level, one would expect the ECB to be more likely to cut the interest rate the higher it is. It enters the regression model with a negative sign and is borderline significant (p = 7.1%). 3 A variable capturing any change in the ECB s interest rate setting from November 2008 onward. The parameter is negative and borderline significant (p = 7.3%). This indicates that, for any given set of economic conditions, the ECB has become less likely to raise interest rates, and more inclined to cut them. The (logarithms of) the PMI, input prices and their product. These are all highly significant (p = 0.2%, 0.1% and 0.1%). Increases in the PMI and input prices are thus the main determinants of the ECB s decisions to change the interest rate. Figure 2 shows the ECB s policy rate and the estimated probabilities of a cut in interest rates in dark blue, of an increase in yellow and of no change in light blue. 2. ECB policy rate and probabilities of interest rate changes Probability Refinancing rate Probability of: Cut No change Increase Source: ECB and EFGAM calculations. The probability of interest rate cuts is generally high when cuts are undertaken, and similarly for episodes of interest rate increases. But there are also some episodes when the model predicted policy changes and none happened. For instance, the model attached high probabilities to the ECB increasing interest rates in 2004 which it did not do. Table 1 provides more information about the model. The probability of an interest rate cut was on average 30% in the months when a cut was undertaken. 4 Furthermore, the probability of an interest rate increase was on average 30% in the months an interest rate increase was undertaken. Table 1. Interest rate probabilities Months with a: Average probability Cut No change Increase Number of observations Cut 29.7% 69.9% 0.4% 23 No change 7.3% 85.8% 7.0% 180 Increase 0.5% 69.9% 29.6% 18 Note: percentages may not sum to unity because of rounding. Source: EFGAM calculations % 2 The model is of the ordered logit type. The regressors are the logarithms of the two variables, and terms interacting them and a dummy variable taking the value of unity from October 2008 onward to capture the impact of the collapse of Lehman. All regressors are highly significant and the pseudo-r squared is 32%. 3 The p-value indicates that probability that the true value of the parameter is 0. Normally, p-values of 5%, and sometimes 10%, are used to judge statistical significance. 4 The fact that interest rate changes generally occur when the estimated probabilities are less than 50% is not surprising. For instance, while the probability of having a car accident per hour of driving varies between drivers, road and weather conditions, and time of day, but is always far below 50%. Infocus July

4 In months in which the ECB decided against changing interest rates, the model assigns a probability of 86% to that outcome, and a probability of 7% to a cut and the same probability to an increase. 3. The current situation Could the ECB decide to raise interest rates or, more likely, tighten monetary conditions now? While the model attaches a probability of an interest rate increase in July 2017 (the last observation included in the study) of merely 7%, there has recently been some indication that the ECB is thinking about scaling back the rate of balance sheet expansion. Of course, if the economic conditions as captured by the PMI or input prices were to strengthen, an interest rate increase becomes more likely. To get a handle on this question, Table 2 shows the estimated probabilities for a set of hypothetical values of the PMI and input prices. To interpret the figure, it is useful to recall that the PMI at the end June 2017 was about 56 and the input price index about 58. Furthermore, recall that when the ECB increased interest rates, on average the model assigned a probability of about 30% to that outcome. It is instructive to consider three cases. 1. Suppose that the PMI were to increase to 63 and input prices remained at 58. If so, the probability of an interest rate increase would rise to 27%. Since the maximum PMI observed in the sample is 62.5, this event seems unlikely to happen. 2. Suppose instead that the PMI remained at 56 and input prices rose to 74. If so, the model assigns a probability of 29% to an increase in interest rates. Since the highest observed value of input prices in the sample is 85.3, this is not an entirely unlikely event. 3. Suppose that the PMI increases to 58 and input prices to 68, if so the model assigns a probability of 30% to an increase in interest rates. Overall, we conclude that an increase in input prices quickly raises the probability of an interest rate increase, in particular if accompanied by a rise in the PMI. As noted above, the estimated probability of an increase in interest rates, for any given state of the economy, fell after the onset of the financial crisis. It is therefore interesting to redo the calculations above, assuming that the crisis had not happened. Table 3 overleaf shows that, under this assumption, the probability of an interest rate increase in June would have been about 30% instead of 7%. And in the estimated probability of an interest rate increase in the three hypothetical cases considered about is about 70%. Thus, given current economic conditions the probability of Table 2: Estimated probability of an interest rate increase for different values of the PMI and input prices (since the start of the financial crisis). Input prices PMI Source: EFGAM calculations Infocus July

5 Table 3: Estimated probability of an interest rate increase for different values of the PMI and input prices (before the start of the financial crisis). Input prices PMI Source: EFGAM calculations an interest rate increase has approximately halved as a consequence of the change in the ECB s behaviour. The main conclusion from Table 3 is thus that if the ECB s responses to economic conditions were to return to those before the financial crisis struck, the probability of an increase in interest rates would rise markedly, given the current state of the economy. likely captures the fact that the transmission mechanism of monetary policy weakened, since the focus of the crisis was in the financial sector. Once the ECB judges that the transmission mechanism has reverted to normal, the reaction function may revert to its original form. If so, the probability of an interest rate increase would rise dramatically. 4. Conclusion The above analysis of the ECB s interest rate setting since 1999 has several messages with regard to how interest rates in the euro area may evolve in the months to come. The likelihood of an interest rate increase, given the current state of the economy, is very low. Given how sensitive the ECB s interest rate decisions have been to the input price variable, and how it has moved in the past, it is likely to be the most important variable determining when the next interest rate increase may come. The PMI is also important, but matters less than input prices. Following the onset of the financial crisis, the ECB became less likely to raise interest rates, and more inclined to cut them, given economic conditions. This shift most Infocus July

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