Wednesday, July 18, 2007

Battle of Wills in the Eurozone

by Claus Vistesen

Cross posted from Alpha Sources

As you may have noticed something is afoot in the Eurozone. The Euro/USD is approaching 1.40, the newly elected French president Sarkozy is testing the patience and resilience of the Eurozone's institutions, and the ECB interest rate decisions have suddenly become much more difficult to call it seems. Regarding the latter point the recent news did not make the life any easier across the trading desks I imagine. As such, we all know that the ECB should raise to 4.25% given the still hawkish discourse but as the data keeps on rolling in the future course seems rather difficult. Lately, we had for example the rather steep fall in German investor confidence in July. Still, with a central bank fixed on inflation and monetary aggregates there is plenty of reasons to stay on the beat at the ECB as headline and structural inflation pressures seem set to bypass cyclical developments in the remainder of 2007. This was further accentuated today by European Central Bank council member Nicholas Garganas who, in an interview, noted the need to further tighten to keep price developments within the comfort threshold at the ECB. However, at this point the trade-off between combating inflation and suppressing economic activity is mounting I think which might very well prompt the ECB to stop sooner rather than later. Regarding a concrete call I maintain that 4.25% is a good call for 2007 and that it will come in September after which the ECB will hold. In this light I think that the implied interest rate from the 3 month Euribor rate which is currently at 4.58% is a bit high given the economic outlook. Yet, this will indeed be a test for the ECB's traditional hawkish stance against inflation since it is likely that structural inflation pressures from headline measures will remain even in the light of an obvious economic slowdown in real terms. Regarding the inflation measure itself the Eurozone wide inflation held steady in June at 1.9%.

On that note, there has also been a lot of flurry recently about Sarkozy's and France's proposal that interest rate decisions might be subject to more vigorous political oversight or whether Sarkozy could be allowed to play his 'get out of jail free card' and implement his announced fiscal plan which means that France would have to deviate from the promise (alongside other member states) to balance its budget in 2010 . Moreover, Sarkozy is of course specifically dissatisfied with the ever climbing Euro and claims that it hurts French exports which is undoubtedly true but what exactly to do when monetary policy is made in Frankfurt. Trichet and Germany for that matter will, of course, have none of this ...

Jean-Claude Trichet's rift with President Nicolas Sarkozy deepened after the European Central Bank chief rejected a French government call for greater political influence in setting interest rates.

Any attempt to influence the ECB violates the European Union's founding treaty, and ``such declarations are not acceptable,'' ECB spokeswoman Regina Schueller said on behalf of Trichet.

Sarkozy, who says gains in the euro penalize European exporters, has clashed with Trichet in an effort to curb ECB interest rates and weaken the currency. While Sarkozy has retreated from a challenge to ECB independence, he said last week that he and Trichet are not ``on the same wavelength.''

Who is right and who is wrong in this case is of course a valid question. However, as I have argued before, from the point of view of Eurozone/EMU governance political intervention is clearly unacceptable. As such, Trichet can really only respond in one way to the French position on interest rates. However, there is indeed a more important underlying issue here which relates exactly to the governance of the EMU system in general. For some well written commentary on this I recommend two recent notes by the Eurozone Watch blog. Lastly, there is of course the perky Euro which also plays an important part in Sarkozy's and France's recent triumphant walk to the Eurogroup meeting. On the Euro I tend to side with Wolfgang Munchau in his analysis recently featured in the FT. As such, it is quite clear at this point I think that the Euro is being pushed up in the global yield game by and large driven by the expectations of interest differentials. The point is, as Munchau argues, that while the Euro indeed at this point is significantly over valued (especially against the Dollar) there are also forces which could lead to further Euro appreciation of the Euro in the short term. I want to emphasise short term here since I am not at all sure how far this can go on which is to say that I am rather bearish on the Eurozone economic fundamentals for the remainder of 2007. Also, as I have argued extensively before I don't see a major tectonic shift from the Dollar to the Euro. Yet, all this could could linger long enough for the ECB to get red ears in the latter part of 2007 and not to mention for Sarkozy to really put on the heat. Especially, if headline inflation continues to drift upwards the ECB will be stuck between a rock and a hard place and at this point the Euro is clearly moving well into uncomfortable territory for e.g. Italy and I also think that Munchau is right on cue to say that Germany might very well get to dislike a strong Euro sooner rather than later.

As such on a final note just watch that Euro go, but also remember that the discourse can quickly change and finally that the ECB is set to be tested on its hawkish inflation stance in a world where economic growth is dwindling and structural and rigid interest rate differentials (and currency regimes) to an ever more increasing degree drive capital flows.

The Wall Street Journal has a well written piece on the Euro in today's online edition. I don't particularly like the narrative on France and how it should it should do more to emulate Germany, we can't all be net exporters you know. But otherwise it is a good preview ... here is a snippet;

Europeans are fighting over exchange rates again, and the rift is instructive about national economic competitiveness. American mercantilists who want a devalued dollar might take note. Almost since he took office two months ago, Nicolas Sarkozy has blamed the euro for La Grande Nation's economic troubles. Claiming that the single European currency is "overvalued," the new French President said exchange rates and "aggressive" monetary policy should be used to spur growth.

His pushiness made Berlin uncomfortable enough to push back -- much to the benefit of Europe, which has little to gain from Sarkozy-style economic interventionism. "It is clear that the independence of the ECB [European Central Bank] is a centerpiece of the euro zone," Angela Merkel said Monday after meeting her French counterpart in Toulouse. Kudos to the German Chancellor for standing up for the central bank's autonomy.

No comments: