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.

Update on Thursday, July 19, 2007 at 06:32PM by CV

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.

Lost in Translation at the ECB?

by Claus Vistesen

Cross posted from Alpha Sources

As per usual I am coming in a bit behind the curve relative to my usual brothers in arms on ECB watching, Chaney/Bartsch from MS' GEF and Eurointelligence. Regarding the actual ECB meeting which was held this Thursday the refi rate was expectedly kept at 4.00% but the interesting thing of course, as ever, was the close attention towards Trichet's comments pointing forward to future monetary policy. So what did he say then? Well, this is the point ... I am really not sure something which is of course mirrored in the analyses linked above by MS and Eurointelligence. Regarding my own predictions I nudged them (reluctantly) up to 4.25% back in the beginning of June but I also recently noted, in a large data review, that the economic outlook was becoming increasingly blurred towards the latter half of 2007. However, with the recent strong PMI readings on manufacturing and particularly services demand I would have expected the ECB to come out much more aggressively hinting to a hike in September. This does not seem to have been the case although of course ECB-speak is not always easy to discern. From a strict economics point of view I think, however, that this is good news for the Eurozone since I quite simply don't think that the ECB should raise beyond 4.25% which still seems to be the lowest possible refi rate on which we are going to end 2007. However, I can also understand Bartsch' frustration (linked above) as a market participant with the recent ECB meeting since at this point it is difficult to see just what the ECB is going to do in the meetings to come. Another hike seems a safe bet but when and of course whether it comes sooner (September) or later (October) will also determine the outlook for more hikes in 2007 and thus positions in the FX market. Having said that, I still think that the official MS ECB forecast of 4.5% is too high and no matter when the ECB chooses to move I think 4.25% is the right call for 2007. On this I am in aggreement with Eurointelligence that if inflation pressures and steady monetary expansion prompted the ECB to move closer to 5% it would seriously cripple growth in the Eurozone where I think that future data will further point to a slowdown in momentum, especially from domestic demand indicators.

On a final note I want to emphasis some of the notes from Trichet's introductory statement. Of course, the main discourse remains anchored in the risks to price stability and especially liquidity conditions measured by the M3 continue to take up a lot of the ECB's attention. However, another discourse string which is emerging relates to, as also covered by Eurointelligence, the increasing pressure on prices from rising capacity utilization and essentially constraints. The following is a relevant quote ...

To sum up, in assessing price trends it is important to look beyond any short-term volatility in inflation rates. The relevant horizon for monetary policy is the medium term. Risks to the medium-term outlook for price stability remain on the upside, relating in particular to the domestic side. As capacity utilisation is high and labour markets continue to improve, constraints are emerging which could lead in particular to stronger than expected wage and profit margin developments. Given the vigorous monetary and credit growth in an environment of already ample liquidity, a cross-check of the outcome of the economic analysis with that of the monetary analysis supports the assessment that upside risks to price stability prevail over the medium to longer term.

From a traditional monetary policy perspective I have absolute no problem with this reasoning. However, the crucial question remains as to why capacity constraints are emerging and whether the drivers of this are structural or cyclical. The main question here is two-fold. Firstly, just how inflationary will decreasing capacity be? Clearly, inflation is seriously mounting in many CEE countries but what about in Germany and Italy? Secondly, even if the grind down of capacity is inflationary how should monetary policy respond? This question is directly related to whether in fact not the decline in capacity is deeply structural as a result of ageing and a surplus of exits over entrants in the labour market. Of course, the continuos process of high growth exacerbates this through cyclical effects. But, my main worry is that ECB could end up chasing its own shadow for all the wrong reasons in the fight against inflation and when at some point push comes to shove in key member countries they might end up finding themselves in a hole with slippery walls.

In Summary

Thursday's ECB meeting left the markets wanting more as regards to future policy decisions from Frankfurt. Concerning an interest rate call I am staying put and with the increasingly blurred outlook for economic fundamentals and now also ECB decisions I think 4.25% is the right number for 2007. My guess is that it will come quick in September with the ECB then on hold for the remainder of 2007. As always, indicators for domestic demand as of course inflation pressures should be watched carefully. Especially, I think that the ECB will be sensitive towards the increasing decline in capacity but sadly as I argue above for all the wrong reasons.

More Evidence from The Irish Real Estate Market

by Claus Vistesen

Cross posted from Alpha Sources

Not too long ago I posted on the connection between construction activity in and net migration in Spain and Ireland. The point was to demonstrate how demographics might have been contributing (and still is) to the ongoing debacle on Eurozone imbalances and whether the zone's economies are converging or diverging. In this entry I field further evidence of this connection from Ireland on the basis arguments and data from a paper by Chris Paris from 2005 entitled; Housing and the Migration Turnaround in Ireland; here are the main excerpt from the conclusion ...

(ROI - Republic of Ireland and NI - Northern Ireland)

Issues to do with migration and ethnicity have changed dramatically in both jurisdictions since the early 1990s. Net population loss through migration was superseded by unprecedented net migration gain between 1996 and 2002. Most incomers around 1990 were Irish born, and there were very few immigrants from Africa and Asia. That pattern had changed significantly by the early 2000s, as the overall level of immigrants had doubled and much larger proportions had been born overseas. There was much less change in NI; indeed, there are signs that the population became more rather than less homogenous between 1991 and 2001. This article has demonstrated strong interrelations between migration processes and housing markets: the surge of immigration into the RoI after 1996 added substantially to growing demand for housing and house price inflation, despite hugely increased new housing production. The age distribution of immigrants, especially the high proportion between 25 and 44, largely explains their impact on housing markets. But the migration turnaround is partly a function of the booming economy, rather than an independent phenomenon, and thus the relationships between immigration and the housing boom represents cumulative causation rather than simple one-way cause and effect. Internal migration has also had major impacts on urban spatial outcomes, as cities and towns across the island have grown spatially, at lower densities, with increasing commuting fields and extensive development of detached housing in the countryside.

Regarding the general argument and my use of it I have some basic qualifiers. First of all, the fact that migration flows should have contributed, along side low real interest rates, to the boom in the Irish property market hardly constitutes economic rocket science at this point. Rather, the point is how property market booms in some Eurozone countries to a large extent is behind what is known and labeleled as Eurozone imbalances. It thus follows intimately from this that demographics have something do to with intra-country imbalances in the Eurozone and crucially also why countries reacted differently to the universal stimulus provided by the ECB in the first years of the single interest rate policy. In the graph below the cardinal point is fielded as it plots population growth in Ireland from 1991-2006 as a proportion between 'natural increase' and 'net migration'. As can readily be seen by comparing the trend in net migration as a share of total population growth with the graph from the other posts the correlation seems strong indeed.

To be fair I should also include the actual figures for population growth in Ireland in the periods used above. As such in 1991-1996 the total population growth was about 100.000, between 1996-2002 it was 291.000 and between 2002-2006 it was 322.645. This of course suggests a general correlation between population growth and construction actvitity/housing booms but it should be fairly obvious that it is net migration we should be looking at since it is a proxy, not only for total population growth, but more importantly for growth in the consuming and labouring cohorts. In this way, migration also holds the potential to rapidly alter the fundamentals of an economy in terms of capacity utilization measured by the output gap.