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The euro area economy is in full swing and the European Central Bank is in the process of “normalising” short-term borrowing costs.  Where will the interest rate journey of the ECB end? A look at the dynamics of credit creation in the euro area suggests that money still costs too little, which would imply further rate hikes by the ECB. At the same time, three factors suggest current economic growth in the euro area is not sustainable. First, a slowdown in U.S. growth will weigh on the euro zone. Second, the effects of previous monetary tightening and upcoming fiscal tightening present an internal risk for euro area growth. And third, Spain, an often-overlooked engine of euro area growth, is likely to slow in the months ahead. In this issue of European Perspectives, I will make the case that risks to growth in Europe outweigh credit creation and should cause the ECB to halt its rate hikes sooner than the market expects. Let us begin with a look at credit.

The dynamics of credit creation in the euro area suggest money still costs too little. Growth in loans continues to accelerate despite the ECB having increased short-term borrowing costs. Loans to the private sector grew 11.4 percent in the twelve months prior to September, faster than when the ECB began tightening policy almost one year ago.

Thus, the double-digit growth rate in credit that banks are extending to households and corporations creates the potential for higher inflation many years in the future. An economy-wide rise in real wages above the rate of productivity is another valid inflation risk, but not a risk we think will materialise, due to the eastward expansion of the European Union (EU). The enlarged EU has increased competition for capital and labor as well as the supply of labor and that will keep a lid on wages.

If credit was the only thing that mattered for monetary policy, then the ECB certainly has a lot more tightening to do and we should expect short-term borrowing costs to rise beyond 3¾ percent. But credit is not the only thing that matters. The real economy and risks around the central scenarios for growth and inflation matter too. And when we look at the balance of those risks, particularly to growth, we think that a number of headwinds will slow the economy down in 2007 and that this will outweigh today’s concerns about credit.

Two headwinds will slow the euro area economy next year. The first is simply slower economic growth in the U.S. and the second is the fiscal and monetary policy mix in the euro area.

The euro area’s high dependence on Spain, the region’s number four economy based on GDP, is a third reason for concern about the sustainability of the current economic expansion. Although Spain accounted for only 13 percent of euro area GDP in 2005, it punches above its weight in many other respects. Spain’s real economic growth averaged 3.6 percent so far this decade, compared to only 1.9 percent in the euro area. Over the same period, inflation in Spain averaged 3.4 percent compared to 2.2 percent in the euro area.

Spain is even more important to the euro area when it comes to the labor and housing markets. Spain created 79 percent of all new jobs in the euro area in the five quarters up to March 2006 and 55 percent of the jobs so far this decade. This is an impressive achievement for an economy with only one quarter of the euro area’s population. A fifth of the new jobs created in Spain so far this decade were in the construction sector. Spain is on track to build at least 750,000 new houses this year, almost half as many as in the U.S. whose population is seven times larger. What caused all the economic fizz?

In short, the answer is cheap money and immigration. The irrevocable fixing of exchange rates that created the euro area in 1999 brought with it a one-size-fits-all monetary policy whose interest rates were arguably too low for Spain. Low short-term interest rates coupled with a mortgage market dominated by variable rate mortgages linked to the money market turbo-charged Spain’s housing market. Low borrowing costs fuelled a mortgage-lending boom, house prices soared and the rise in real estate wealth underpinned consumption and more residential investment. This virtuous circle is now starting to change.

The ECB’s tighter monetary policy appears to be gaining traction in this small region of the euro area, due to the structure of Spain’s mortgage market. Nearly all (97 percent) of Spanish mortgages have floating rates linked to Euribor, according to INE, Spain’s National Statistics Institute. Thus, Spanish mortgage interest rates have increased almost one-for-one with the ECB’s rate hikes, rising from 3.4 percent in December last year to 4.4 percent in August 2006, as shown in Exhibit 2. As a result, Spain’s housing market is starting to cool down, as figures released in October by the Housing Ministry in Spain confirm. House price appreciation slowed to 9.7 percent over the last year, the first time in five years that prices have risen by less than 10 percent. In some areas, such as Madrid, prices even started to fall.
 

Immigration also played a role in Spain’s impressive economic growth. Because of their open coast lines and proximity to North Africa, Spain and Italy are the main destinations for many immigrants who risk their lives crossing the Mediterranean in search of a better life in Europe. Many of those immigrants were among the 700,000 people who applied for residency during a three-month amnesty the Spanish government declared last year for illegal immigrants. To qualify for amnesty, immigrants had only to provide proof that they had resided and worked in Spain for at least six months and that they have no criminal record.

So going back to our initial question, where will the ECB end its journey to normalise interest rates? Normalisation implies returning borrowing costs to a rate of interest compatible with output growing at its potential and stationary inflation. The Swedish economist Knut Wicksell coined this the natural rate of interest. A reasonable estimate of the natural short-term nominal rate of interest in the euro area is 3½ to 4 percent. That’s based on a rule of thumb that the natural rate should lie slightly below the potential rate of nominal economic growth, which in turn is made up of a real potential economic growth component and an inflation component. Real growth in the euro area has averaged 2.1 percent over the past 10 years, and the ECB’s objective is to keep inflation close to but below 2 percent. Thus, the euro area’s real growth potential is about 4 percent and the natural rate of interest should lie somewhere below that level.

Financial markets currently expect the ECB to stop hiking at 3¾ percent, right in the middle of the range for the natural rate. But given the risks to economic growth in the euro area, we think the ECB should pause at 3½ percent and stay there well into 2007. We think that this is a level more consistent with a neutral policy stance because the nominal rate of economic growth reflects the long-term average return to capital, while the short-term rate is credit and duration risk free. Therefore, the short-term rate should yield slightly less than the average return to capital. A neutral 3½ percent would hence mark an appropriate endpoint for the interest rate journey of the ECB.

As bond portfolio managers, however, we are susceptible to focussing too much on what central banks should do as opposed to what they will likely do given their legacy and leadership composition. So when we observe that euro area inflation has consistently exceeded both the midpoint of the ECB’s forecasts and upper bound of its target in recent years (Exhibit 3), we would not be surprised to see the ECB raise borrowing costs to 4 percent next year in order to cement its inflation fighting credibility. Now that certainly would be a headwind. For the bond market, the risk of further monetary tightening coupled with those headwinds from home and abroad and low inflation is that the yield curve inverts with yields on long-maturity bonds declining. 

Executive Vice President