Tough Times at the ECB

by Claus Vistesen

cross posted from Alpha Sources



I have, at times, levied quite an extensive critique towards the ECB at this space since I have felt and indeed feel that the current campaign which so far has taken the ECB up and upwards with respect to interest rates has been too scarcely tuned in to the economic fundamentals present in many Eurozone countries. Of course, at this point in time the ECB has been caught up by current events as the general market turmoil has forced the bank to hold rates as well as actually providing liquidity to an otherwise almost Vermouth dry interbank lending market. However, when we look forward to this Thursday's interest rate meeting we must also consider the real and essentially nasty bind which the ECB faces.
In this way and following my last remarks in the context of an ECB meeting downside risks to growth and the general workings of financial markets are plenty which is ultimately also why the ECB has been forced to scrap what was otherwise judged (although not by the author of this blog) to be a sure final refi level of 4.5% at the end of 2007 in the Eurozone. Yet, the ECB is fast running into what essentially must constitute something of a brick wall with the recent rather violent surge in Eurozone wide inflation. The readings for September was for a hefty 2.6% increase in the HICP well above the 2% target and with the recent flash estimate from Eurostat suggesting a 3% inflation increase the ECB is indeed stuck in quite a bind. As reported by Bloomberg ...
European inflation accelerated in November to the fastest in more than six years, adding pressure on the European Central Bank to raise interest rates even as economic expansion cools. The inflation rate in the 13-nation euro area rose to 3 percent this month from 2.6 percent in October, the European Union's statistics office in Luxembourg said today. An index of executive and consumer sentiment fell to a 20-month low of 104.8 from 106 in October, according to a separate report. A 75 percent surge in oil prices since mid-January and rising food prices are driving inflation further above the ECB's 2 percent ceiling. At the same time, easing economic growth may restrain ECB policy makers from increasing interest rates to slow the pace of price increases.
Of course, economic convention is not entirely without tools to address such situations. At least we need to remember that there are many kinds of inflation and at this point in time we need to ask ourselves whether the rather stark increase is driven by demand-pull or cost-push factors? Clearly, this should not make us deviate from the main point but it does serve as a nice qualifier I think as we are bound to move into a territory where decisions either way from the median will be watched and scrutinised closely. One example I do feel the need to point out is the following from Stefan Karlsson who, I should immediately say, regard as a fine economic commentator.
Yet despite this surge in both monetary and price inflation, the ECB betrays its legal obligation to hold M3 growth at 4.5% and consumer price inflation below 2% by failing to raise interest rates and by offering "emergency loans" to failed investors.
Now, I want to reiterate that I don't think complacency is ever warranted when it comes inflation but we also need to remember that the world is a bit more complicated than just raising rates until some essentially arbitrary targets are within line. In fact; I would argue with some force that traditional instrument rules for monetary policy in the current environment should be treated with some care. As such, we need to consider the point that raising rates actually might be counterproductive to reigning in monetary growth since in a world where capital flows are driven increasingly more (at least on the margin) by moves in nominal interest differentials which essentially are very wide at the present time raising rates will only exacerbate the pressure. Quite simply, there is a lot of liquidity out there and anybody signalling to reign in monetary supply growth by raising rates will only end up pulling even more money in on the short end of the yield curve. At least, I think we need to consider these kind of dynamics and once we are letting ourselves ask some of the right questions we will see, I think, that a whole gamut of issues are present which makes that ever so famous conventional wisdom rather ill-equipped to handle the situation. Furthermore, and in the immediate context of the Eurozone and the current financial market turmoil I don't think that we should, for one minute, let ourselves loose sight of what is going on in in the interbank market. Edward and Eurointelligence recently had some fresh reports on the standing on this topic. Now, a lot of things can be said about this but the most important thing is that the conditions in the interbank market essentially is a proxy for much tighter credit and liquidity conditions than is otherwise alluded from the HICP and corresponding refi rate stance of 4%.
So, what will it be on Thursday then?
Well, and despite that pretty nasty HICP reading from October I see a holding operation as does the majority of other economic commentators. However, and this is also where I ultimately agree with Karlsson inflation is becoming a serious concern at these levels and as such it will be very interesting to see how Trichet narrates the situation. One surprise here could be for Trichet to signal an imminent raise from the start of 2008 but I see this as rather improbable at the moment with the economic momentum destined to head south. Rather, I expect citation of the ongoing financial market turmoil as a reason to stay put which will be a continuation of the current wait and see approach adopted by the ECB. As for the general market implications the coming week will be an interesting one indeed. Not only is the ECB meeting but also the Bank of England, the Bank of Canada, the Royal Bank of New Zealand, and the Royal Bank of Australia are meeting to decide on interest rates. Of these meetings the one at BOE is the most interesting one since it remains unclear whether the BOE will actually lower rates or merely stay on hold. As for the ever recurring debate on the EUR/USD it started off this morning at shy just of 1.47 flat and although of course the ECB meeting and the chosen discourse will have an important impact it is widely held that Friday's nonfarm payrolls will have a major impact on the Fed decision come next week. So saddle up for what undoubtedly will be an interesting week. For the record the consensus has it that all central bank meetings above will see holding operations with the dark horse being the one at the BOE.