Tuesday, October 11, 2005

ECB Interest Rate Policy

Brad Setser has a post today on Kate Moss, not provoked by her evidently economically intriguing modelling properties, but due to the Kate-Moss-thin credit-spreads which Bloomberg's William Pesek refers to in this article. What really turns Pesek on it turns out isn't Kate Moss at all but the possible existence of links between China's economic boom and the recent surge in popularity for credit derivatives.

And it is in the context of this evolutionary chain that Brad Setser's work on China and Systematic Risk offers itself as some kind of missing link.

But as I continued reading Brad's post, and even more so Pesek's argument that current global growth "comes against the backdrop of a readiness by China -- and other Asian central banks -- to keep its currency from rising and the U.S. dollar from falling. It has put a floor under the dollar and a ceiling above U.S. debt yields.", I couldn't help but forget Kate Moss and move onwards and upwards to the issue of the current interest rate policy debates revolving around the ECB.

Essentially I think there's a topic here which isn't getting the discussion it deserves. The US Federal Reserve is currently taking responsibility for attacking some of the global imbalances which everyone is talking about. It is doing this by starting to target house prices in the US. On this topic see this post from Stephen Roach, and this speech from Alan Greenspan, in particular this:

"...it is difficult to dismiss the conclusion that a significant amount of consumption is driven by capital gains on some combination of both stocks and residences, with the latter being financed predominantly by home equity extraction. If so, leaving aside the effect of equity prices on consumption, should mortgage interest rates rise or home affordability be further stretched, home turnover and mortgage refinancing cash-outs would decline as would equity extraction and, presumably, consumption expenditure growth. The personal saving rate, accordingly, would rise."

"Carrying the hypothesis further, imports of consumer goods would surely decline as would those imported intermediate products that support them. And one would assume that the U.S. trade and current account deficits would shrink as well, all else being equal. How significant and disruptive such adjustments turn out to be is an open question."

Ergo, squeezing mortgage rates squeezes consumption which ultimately hits imports and reduces the US trade and current account deficit. This is thus the path on which Greenspan has embarked.

There is a problem though..... if the Fed continues the interest raising process, but the ECB stays put, the dollar will continue its gentle rise driven by the yield differential, and this will offset what Greenspan and Co are trying to do with the US CA deficit.

So..... my guess is that at the ECB they are already coming under significant pressure to raise in the not to distant future simply to support the Fed initiative (which I am sure Trichet would be the first to accept is in everyone's interest). This pressure was, I feel, evident in the emphatic statements coming from Trichet after the last ECB meeting, statements which are, perhaps hard to comprehend if you don't look at the complete picture.

But of course, raising eurozone rates will be controversial politically, since in the case of Germany (and almost certainly Italy) it is hardly indicated.

Bloomberg this morning draws attention to the great lengths to which the EU finance ministers went yesterday to stress that they didn't think inflation was a great looming problem in the eurozone. This can only be read as directed at the ECB.

Reporting on the meeting Austrian Finance Minister Karl-Heinz Grasser stressed that he didn't " see any inflationary pressure..Interest-rate moves are not necessary, at least this year.''

Economics Commissioner Joaquim Almunia basically backed them up: "There continues to be no evidence of second-round effects stemming from higher wage growth, but there is no room for complacency,''

I imagine they really loved this over at the ECB and, of course, across the pond at the FED.

Basically what I am arguing here - for reasons which flow essentially from the great Kate Moss debate - is that either the Fed stops, or the ECB has to raise. Globally, if you take the rebalancing arguments seriously the first can't happen, so the second - at some stage - has to. But just watch out for the fall-out.

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