cross posted from Alpha Sources
Between the rumbling in financial markets, a EUR/USD touching an all time high, a French president smelling blood, and what seems to be subtle yet clear signs of a turning point in the economic fundamentals it has been difficult indeed to catch a breath as a Eurozone watcher. Now of course, we are nearing the proverbial end of the line and with tomorrow's ECB meeting we should expect to get some kind of indication of the kind of strategy the ECB is playing in a context of a EUR/USD on helium, down trending economic fundamentals, and of course the lingering threat of inflation. In this sense, it has not only been my colleague Edward Hugh (and myself) who have been looking for Trichet lately in order to dissect what he in fact intends to do and say about what is happening. Also for example Morgan Stanley has (Chaney is here), albeit ever so subtly, suggested that perhaps it was due time that monetary policy makers in the Eurozone began to correct to what seems to be the inevitable fundamentals. And speaking of those fundamentals there is certainly enough bad news to pick from. In Italy retail sales slumped to a two year low a trend mirrored in Germany where retail sales also fell. More generally the general index of manufacturing growth constructed by the Royal Bank of Scotland also fell recently.
In short and if there ever was a time to pull out the proverb of being stuck between a rock and a hard place now would be as good a time as any in the context of the ECB. Of course, none of this is particularly easy; especially not since the ECB is now, as has been the case before, faced with political pressure to do something and if there is something central markets and financial markets don't like it is when politicians fiddle with their business regardless of course whether in fact the advice might be prudent or not. In my notes linked above I have dealt with this quite extensively but I can also recommend a recent piece by Wolfgang Munchau in the FT in which he examines the ECB's potential moves; and his message;
(...) I see relatively limited room for manoeuvre. The ECB’s official short-term interest rates will probably stay at 4 per cent for a considerable period. The ECB will not start to cut interest rates until inflationary pressures subside, and until there is some hard statistical evidence of an economic downturn. At present, this evidence is confined to sentiment surveys.
In principle I think it is difficult to completely disagree with this call. Clearly, given the fact that inflation is set to remain elevated in the remainder of 2007 and perhaps even beyond a sudden sea-change at the ECB in the form of targeting some kind of arbitrary EUR/USD rate would be equal to complacency and this I think will not happen. However, I do have some qualifiers which are rather important. Firstly, we need to go back for while to the time in the spring of 2006 when Japan ended ZIRP and consequently when the central banks presiding over the G3 currencies (the BOJ, the FED, and the ECB) all 'decided' that now was the time to mop up excess global liquidity. In this way and as should be rather clear at this point in time the BOJ has not exactly been able to follow through on the promises, in the US the FED got and is still sidetracked by a lingering depression in the housing market and only at the ECB have we seen hiking trip which has taken the nominal refi rate to 4.00% in the Eurozone. Secondly, we can of course add the extra spicy ingredient that the US housing market debacle has caused a severe commotion in financial markets and specifically in the very sector (housing) which has been paramount in driving growth in the current cycle both in Europe and in the US. However, and this I think is important the current slowdown of growth in the Eurozone is not caused exclusively by the turmoil in financial markets even if of course it has not exactly helped. Remember then what we talked about in the beginning of 2007 as a triple whammy to the Eurozone economy in the form of higher ECB rates in themselves, a slowing US, and fiscal tightening in key member countries.
So, in looking forward towards tomorrow's meeting we might not want to forget entirely the underlying fundamentals in play here. Yet, one thing is what I perceive to be the fundamentals and another thing entirely is how markets see and play things. In this sense tomorrow's statement from the ECB is ever so important. As such, we must remember that the story of the rise of the EUR/USD in particular as it has been told since Q3 2006 has been one of a persistent play on the closing interest differential between the Fed and the ECB as the latter continued to raise when the former chose to stand firm. This has subsequently driven out the narrative of de-coupling and whether the Eurozone and indeed the global economy could weather a US slowdown or not. Yet, this discourse has also tended to miss the overall point in the sense that while indeed the global economy is changing so that not only the US is doing the heavy pulling the real test of de-coupling would be whether the importers could turn into exporters and vice versa. Specifically in the context of the Eurozone de-coupling has even been narrated implicitly in the context of a process of rebalancing of the global macroeconomic imbalances and whether in fact we were standing before a tectonic shift in which the Dollar tumbled to reflect the large US external balance and where the Euro subsequently ascended to superiority. Of course, I have on several occasions argued why I don't think this will happen but it is a little bit difficult to deny that at this particular point in time this is where we stand.
What to expect tomorrow then?
In this way my main message to investors, analysts and of course the splendid folks at the ECB comes in the form of a question. Do we really believe that the Eurozone can de-couple? This I think is the main nut to crack here and we must remember that in the context of the current environment where the Fed is more likely to go further South than the opposite any kind of uttering of vigilance against inflation (warranted as it may be) will be interpreted as a sign that European policy makers at the ECB believe in de-coupling and that the Eurozone can tolerate tighter monetary policy in an environment where the Fed is lowering. As I have already hinted I think de-coupling is wholly unrealistic given the underlying economic fundamentals but this is nevertheless where we are at the moment.
Moving on to the more mechanical outlook on tomorrow's meeting I would indeed be surprised if inflation is not mentioned, especially since the latest flash estimate from Eurostat suggests that core inflation crept above the ECB target of 2% in August. I don't think that we will see any moves on the rate front and as such I would expect the ECB to issue a statement poiting towards stop-and-go position. In keeping with tradition in relation to regular ECB-speak I don't expect Trichet to utter the word 'vigilance' but much more interesting will be whether the ECB still sees the monetary stance to be accommodative or not? This will go along way to show how the bank views the obvious trade-off at this point between combating inflation and risking to throw the Eurozone and perhaps more specifically key member states (Italy!) into a recession by the beginning of 2008. I am also looking for notable references to the continuing difficulties with the stabilisation of the interbank market where the interest rate still remains rather far above the target at 4% and thus also a linkage between the economic outlook and the ongoing reappraisal of risk in financial markets.
In essence, it is very difficult however to gauge what in fact the ECB is going to focus on tomorrow which only makes it all the more interesting
What I would like to see but won't get? Well, I have only a couple things really. I'd wish that the ECB would consider what is going on in the CEE economies too since many of these countries are pegged both formally and effectively and given the nature of the external balance situation as well as the effect of a rising Euro this situation really is train wreck waiting to happen. Secondly, I would also like to see the ECB putting this into a global perspective of de-coupling and the imbalances instead of looking at those tedious measures of liquidity and inflation. I am not asking for complacency but I am saying that central banks in the current environment are likely to bring in more liquidity by raising rates as well as we need to ask ourselves whether in fact the current upward tendencies of inflation needs to be treated using textbook remedies.