Wednesday, May 07, 2008

Wag the Dog?

by Claus Vistesen

I am sorry to paraphrase, arguably, one of Hollywood's better conceptions; but having left the last Fed meeting and looking towards Thursday's corresponding action in London and Frankfurt I cannot help but feel that the tail just might be wagging the dog this time around. One thing is certain; ever since the credit turmoil began and the Fed started to aggressively slash the nominal interest rate to ward off disaster it was assumed ex ante that the ECB and perhaps other of the global central banks would follow as per function of the lack of de-coupling. Now, as investors seem to settle on the notion that the US is in fact in a recession it may be time to turn towards another of the bogey-man out there in the form of inflation.

I am still a bit in limbo as regards to where I see things moving. I still see the ECB cutting rates at least once in 2008 on the back of an accelerated slowdown in the Eurozone but that move won't come on Thursday when Trichet and co. are likely to reiterate the chorus that inflation remains the variable to watch. Yet, this was also always going to be the main rub for central bankers in the sense that in a stagflationary environment their main and essentially only weapon of choice becomes increasingly blunt. Quite simply, in a world with free movement of capital, excess liquidity relative to the capacity to absorb it, and lingering structurally inbuilt interest rate differentials it is not at all certain that toggling nominal interest rates higher will have any meaningful effect at all.

On the contrary, as we have seen across the global economic edifice many economies, emerging as well as developed, have been hard at work trying to hold off the pressure from capital inflows even in a situation of rather large external balances. Thailand would be a prime example here but more significantly in a global context such heavy weights as India, Brazil, and China on whose shoulders many hopes of recoupling lie have felt the pressure of the international hunt for yield. Obviously, this is not the case everywhere and across the Eastern European region as well as in Iceland external deficits are fast becoming a real issue.

So, what to do for those poor central bankers and more pertinently what does it mean that they don't seem to agree on what to put first in line of priorities assuming that they can see that there are both growth and inflation risks.It is in this light that I am suggesting that the dog is getting wagged rather than, as we have seen, the tail. Consequently, meetings at the BIS which began this Sunday had central bankers worryingly mainly about high and rising inflation. And what is more; they are even waking up to the fact that they stand largely helpless in doing anything about it at least in so far goes as a given central bank trying to quell the inflation bonfire in its respective domestic economy.

If we home in on the ECB who is deciding on interest rates later this week it even seems as if sentiment is solidifying behind the ECB's vigilance against inflation. Solidifying sentiment is of course unequivocally good and in a European context it even prompted Luxembourg Finance Minister Jean-Claude Juncker to exclaim that the ECB had become the inflation fighting machine we all wanted. So far Trichet and his minions have tried hard to live up to this adamant label. On several occasions both in the context of interest rate meetings and beyond have we heard hawkish statements from the ECB much to the chagrin of France's finance minister Christine Lagarde; I would imagine that they are also keeping more than a weary eye in Spain and Italy.

As I have noted before the ECB is now faced with a growing divergences between the Eurozone economies. We don't have to look beyond the most recent data snippets to see this. As Edward details over at Global Economy Matters just about everyone save perhaps Germany is now beginning to feel the pinch. Spain and Italy in particular seems to have entered what appear to become very severe corrections. To make matters more complicated the service PMI from Germany actually rose today while the aggregate Eurozone indicator stayed very close to th 50 mark of zero expansion (in fact, it rose a nudge). Thus, I still maintain my view that the ECB will soon have to go for growth rather than inflation. Two issues are however important here. Firstly, I want to reiterate a point I made on an earlier occasion that we will need to see a material slowdown in Germany before the ECB moves. Secondly, the newly found focus by a wide range of observers and investors on inflation relative to downside economic risks mean that the ECB may just have a stronger hand with respect to an adament view on inflation.

Not everybody agrees though. Over at Morgan Stanley (may 2th GEF) Joachim Fels and Manoj Pradhan continue their ongoing global inflation watch and they seem to share my view (or I theirs if you will). Consequently, Fels et al believe that central banks will soon be inclined to go for growth rather than inflation.

We think breakeven inflation rates are distorted downwards by safe
haven buying and collateral concerns, and true inflation expectations in the
bond market may thus be higher. However, even taking this factor into
account, we think investors are still too confident in central banks’ ability
and willingness to stem higher inflation in the coming years. Thus,
central banks are likely to keep missing their inflation targets in the coming
years, and both true inflation expectations and breakeven inflation rates should
rise over time.


(...) we also think investors are still too confident in central
banks’ ability and willingness to stem higher inflation in the coming years. Our
bottom line: central banks are likely to keep missing their inflation targets in
the coming years, and both true inflation expectations and breakeven inflation
rates should rise over time.

Behind this quote lies a critical narrative in which central banks falsely choose to neglect inflation risks in an effort to boost growth. As I have argued before I don't tend to see it this way or more specifically I think the current situation is a hell of a lot more complicated than blaming it on the central banks. Recently, I took a swing at precisely Fels and his colleagues for their analysis showing how in fact current interest rates in the Eurozone are accomodative. I think such claims are very hazardous and just as it may be a question of 'missing markets' it is also a question of an unprecedented process of global recoupling (unwinding of population and economic imbalances). Coupled with lingering wide global interest rate differentials this means that no one really knows what 'global capacity' is and much more importantly whether capital is being allocated in an 'efficient' manner. And speaking of which; recent news from the fx markets suggest that the EUR/USD is not as perky as it used to be. 1.60 consequently seem to have been the interim borderline.

There can be many reasons for this (see Macro Man here) but more prominently is of course the question of whether those big wallet central banks are beginning lose their fondness for the Euro. In this way, a large part of this boils down to the whole Brad Setser/Macro Man detective work about just what China and the Petroexporters are doing since they are the big price movers and the speculators simply try to go where they go. As Macro Man notes It could seem as if someone with a big pocket sold off some Euros at 1.60 and now that we are hovering at 1.55 it will be interesting to see what happens next. Obviously a hawkish statement come Thursday could take it right back. Most still see the EUR/USD heading lower though but the key is whether we will see more rallies before this happens. Stephen Jen (permalink later) is musing about a EUR/USD at 1.40 at year's end. I fundamentally agree with him but there is also a strange lock-in effect here since who the hell knows what the equilibrium is? My guess is that as re-coupling moves on (and it will, just look at Brazil and their upgrade to IG) the EUR/USD will find a balanced level at some point but as long as strong interests are vested in terms of a fixed currency regime (or not) we could see a lot of volatility.

So, who exactly is wagging who here?

It is obvious that growth divergence dilemma persists for the ECB. If anything, it has now grown worse with the recent abysmal data from Spain and Italy at the same time as Germany continues to run on the last legs of strong external demand. At the same time inflation continues to linger at levels far above the formal ECB target even though we actually saw signs of abating pressures recently. In this context, it may seem as if the market discourse has changed a bit in favor for the ECB's strong inflation stance as rampant food and energy prices are beginning to pop up on the agenda. I tend to agree with Fels et al. however when they say that the ECB ultimately will lower rates in 2008. I don't agree with the whole 'inflationist central banks' narrative however since I think the situation is a whole lot more complicated than as such. As for concrete calls it is pretty obvious that the ECB is going to stay pat this Thursday. Coupled with today's devastating news from the US housing sector (Fannie Mae's trip to the pillory is covered by Felix here) and the subsequent ripple effect in the debt markets a hawkish statement could take the EUR/USD back towards hitherto record levels of 1.60.

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