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Tuesday, June 24, 2008

The ECB - All Talk, No Walk?

by Claus Vistesen Copenhagen

A good relationship need not, at each and every moment in time, be characterised by passion and desire. In fact the relationships which best endure the relentless erosion of time are often those where mutual respect and acceptance of difference form the cornerstones. Although I am, I have to admit, by no means an expert on this topic I would imagine that some such rule of thumb is embedded at the heart of many a marriage councilors' cookbook of fundamentals. Every chain has its breaking point however, and it seems that the central bankers' hitherto passionate love affair with inflation targeting is beginning to suffer the unforgiving attrition of time as the chill winds of the global credit crunch and rising inflation start to make the going rougher. At least it is hard to avoid the impression that certain that as some of the key components of the global economy are now noticeably losing momentum, our central banks have begun to diverge on a number of crucial issues, and in particular on the key question of the day: how to break lose from the growing yoke of stagflation.

In an immediate market context there can be little doubt that the dominant discourse amongst market participants - and at a second order level amongst monetary policy makers - has shifted sharply of late from how to sustain growth to how to contain inflation. As I argue in more detail here, this is the context in which the hawkish message which has been emanating from recent ECB meetings should be seen. Yet, I also think that the ECB is acting as the proverbial marriage councilor here by attempting to solidify the bonds between central banks and a nominal inflation target. There certainly would seem to be a need for such an arbiter.

Regular readers of the RGE blogs (and in particular the Latin American vintage) will already be pretty familiar with the comings and goings of Brazilian monetary policy and the ongoing search for an adequate output gap with which to steer the setting of nominal interest rates. In Turkey, on the other hand, monetary policy makers have simply opted for an upward adjustment of the inflation target whereas others have headed off in the opposite direction and decided to simply jettison some variants of core inflation as formal policy targets. Generally speaking, the ECB seems to have decided to situate itself in poll position in its attempt to stand its ground on the inflation issue, with Fed chairman Ben Bernanke moving in with a much more hawkish tone hot on the heels of the ECB rate hike threat, whilethe Bank of Canada also decided to shelve what was otherwise thought to be a done-deal of a rate cut (see Morgan Stanley's Joachim Fels and Manoj Pradhan for a neat overview).

Astute watchers of global monetary policy will already be experiencing more than a faint whiff of deja vu here, since it was only as recently as the start of 2006 that global central banks decided to embark on what was then widely held to be a joint hiking exercise to try to soak up all the "excess liquidity" which seemed to be in danger of flooding the global coffers.

Yet, strong head winds in some key economies - and in particular the emergence of the sub-prime crisis last August - effectively prevented that particular monetary policy expedition from getting too far beyond basecamp, and since August 2007 the Fed has been heading full speed reverse gear down towards sea level, while the BOJ was never really able made it off dry land. Only the ECB has not (yet) opted to yield to the inclement weather and head back down the mountain. In fact, and as per my earlier reference to recent events, the ECB is now trying to re-muster the forces, and animate its peers to make one more attempt to scale the north face of the mountain, and most notably in this regard seeking a tandem assault in association with its erstwhile colleagues over at the US Fed.

However, a strange bout of amnesia seems now to have many pundits and analysts in its grip. In particular, the Federal Reserve has been taking a lot of flack for being so aggressive in lowering interest rates, in turn fueling and, according to many, unduly fomenting an "undesireable" appreciation of the Euro, not to speak of throwing more fuel on the fire of those global inflationary pressures. In fact, the Fed has been coming under more or less constant criticism since the start of the current easing cycle for acting recklessly in the face of mounting food and energy price rises which threaten to take us all back to that illusive 70s show we all so dearly wish to avoid attending.

The funny thing here is that if the US is now getting flack for pouring too much liquidity into the global economy few seem to be mentioning the real ultimate liquidity provider; Japan. What is most noticeable here is the speed with which one scapegoat for excess liquidity (Japan) has been traded for another (the US). You really don't need any kind of ultra sophistocated time machine to work yourself back the mere 18 months or so which now separate us from the days when G8 statements were focusing most of their attention on the Yen and when it was the BOJ's near ZIRP which was under permanent scrutiny.

At the present time the global economy needs and wants a strong USD, or at least this is the message which has emerged from recent G8 meetings. However, if this is the objective then the G8 discourse on the USD has not exactly been effective, and could almost be termed counter productive. Indeed, if a stronger dollar was what you were looking for, it might be thought that stern talking from Bernanke before Trichet started mentioning rate hikes might have been a better way of playing it.

Of course, things are never that simple, and G8 statements should never be taken at their face value, since in the context of the current global imbalances the argument for a weaker USD is pretty overwhelming. The main issue is really that the argument for this weakening being largely vis-a-vis the Euro is a lot less convincing. Thus, for as long as China and the Petroexporters remain ardent in continuing with their pegs it is hard to see how the USD can fall without some currency (in this case the Euro) or currencies (a basket perhaps) taking up the baton from the US by providing some sort of additional external deficit cushion with which to suck up all that excess liquidity. Indeed it could be argued that the US, by not (in any practical sense) giving a damn about the USD, is precisely trying to ease itself out from beneath the yoke of global consumer of last resort under which it has been labouring.

The reason I am emphasising the above point is simply that I think excess liquidity has deeper structural roots than simply the presence of low interest rates. More specifically; I think that there are reasons that run well beyond mercantilism why some countries (e.g. Japan) simply cannot muster the strength to raise interest rates. Indeed, in a world of excess liquidity where money goes for yield raising interest rates is not a straightforward remedy (as Stephen Jen nicely argues in this timely piece).

If you add to this new global dimesion in regional monetary policy the fact that price pressures are largely of a cost-push headline nature (domestic demand in the Eurozone has been weakening steadily for six months now) inflation targeting clearly becomes a difficult stunt to pull off. Nowhere is this truer than in the Eurozone where inflation targeting has also, since the Fed decided to let go of the reigns, been associated with a marked appreciation of the Euro in the expectation of a tectonic shift whereby (at least in the eyes of one group of analysts) the Eurozone could take over the US role as the counterweight in a revamped version of Bretton Woods II. This old narrative of decoupling was of course, from the start, on shaky grounds.

Stepping out for a moment from our brief helicopter tour of global monetary policy, where does all of this leave the ECB's present policy decisions, and what are the challenges these are likely to meet going forward?

Certainly the ECB is expected to raise rates come next meeting. Anything else would be a mistake in terms of continuing to nurture the still fragile credibility of the institution. We should remember here that the last time the ECB all but pre-committed to a rate hike back in September 2007, they had to abandon. Save for a financial market meltdown I don't think the ECB will be deterred this time around. The question really is how far the ECB will dare to take the hiking process and, crucially, whether the ECB will continue to raise into what is now clearly becoming a German slowdown (and this, and this)? What we do know is that so far the ECB has not been moved by the unfolding economic problems which beset two of the Eurozones "big four": Italy and Spain. Consequently, and as the Italian statistical office manged to wind itself back up to start delivering timely data, we recently learnt how Italy just managed to avoid a recession (for now) with flat lining growth rates over the last two quarters. As regards to Spain I don't think I need to say much but to point to Edward's elaborate piece posted at this space. The situation is grim indeed and Spain has without a doubt suffered a structural break and what awaits now is a long grind to rebalance the economy.

This brings us to another of the ECB's problems; internal Eurozone imbalances. This has been the subject of a whole series of posts and already a considerable amount of ink has been spilt scrutinising these issues. Contrary to what many think the problem is not so much the business cycle itself which is fairly synchronized (yep, Germany will fall too). Rather it is the level of growth as well as the divergence in external balances which is the problem. These imbalances or rather the perception of them is creating all kinds of kinds of issues; some taking the form of theatricals and some are more serious. In the first category voices have been reporting how German consumers were reluctant to receive and hold Euro notes from Spain, Greece and Portugal. Chuckling now are we? Well, you shouldn't. More seriously then was the recent news that the Spanish treasury announced that it would no longer accept Italian government paper as backing for short term loans. Arguably this could resort under the theatricals label too but it does latch on to the specific problem with Italy, that of the +100% debt to GDP ratio which, with the current and indeed potential growth rate, and the liabilities entailed by having a rapidly ageing population, looks set to climb and climb, recent promises to the contrary by the newly elected Italian government notwithstanding.

Imbalances or not the Eurozone is now decisively slowing and the ECB should be happy that the next interest rate meeting is not far away. Moreover, the most recent commentary from ECB VIPs appear decidedly out of touch with the underlying reality. In this way, council member Lorenzo Bini Smaghi was quoted saying that a hike of 0.25% would be just what was needed to bring inflation back into check within a period of about 2 years. The idea that a 25 basis point hike would constitute the holy grail to bring balance and prosperity back to the Eurozone economy is highly questionable I think, and in fact is almost laughable in its "political correctness". In fact, one can only interpret such comments as a sign that the ECB won't raise beyond the pre-committed hike come next meeting, which really adds a dimension of farce to the whole sabre rattling process. How can you possibly hope to steer expectations towards the idea that you will do whatever is necessary to bring inflation under control, if some of your key actors are stressing that what you are really doing is going through the motions? Don't threaten to go to work on those pumping irons if you haven't been to the gym of late would be my advice.

In a more immediate context the ECB's timing seems, being rather tongue in cheek for once, to be quite impeccable. The latest indicators from the Royal Bank of Scotland showed that manufacturing activity in France, Italy and Spain contracted in June. Only in Germany did the manufactures manage to eek out a small increase. Furthermore, the latest GFK consumer confidence reading from Germany also showed decline. Lastly, and to top off the cake with the proverbial cherry official German authorities predicted recently that the economy would mostly likely contract in Q1. In itself, this is not so strange after the bumper reading of 1.5% q-o-q in Q1. However, it does also represent and interesting factoid in the sense that the ECB will now have to decide whether to raise rates into what is obviously becoming a German slowdown too. In Germany's case the export link with Eastern Europe is particularly important. Any problems in Eastern Europe which go beyond the simply trivial and the German export machine will have to wind down, and wind down significantly.

Walking the Walk?

It is very difficult to see how the ECB can (or would want to) avoid raising rates at this week's meeting. Even though virtually all the incoming data since the last meeting has been pretty abysmal and despite the dovish hints from Bini Smaghi and others, I don't think the ECB will ditch a pre-commitment again. This is far from certain however. The most recent remarks from Trichet have pundits scrambling for a foothold; did he downplay the hawkish stance or reinvigorate it? In general, investors seem to be smelling a rat when it comes to an ECB raising more than once. Needless to say I also think that this a dangerous road to take. The point here is not simply a result of the fact that the raise comes at a time when the cycle has most decidedly turned, but because the ECB may well end up with a lot of egg in the face for what comes next. Essentially, I don't think the ECB can do much to halt the inflation currently rolling (or more aptly sailing in?) but one of the longer term consequences of this weeks decision may well bethat the ECB is forced to keep rates much lower for much longer on the back of the mess which is about to unfold.

As I noted after the last ECB meeting I actually respect the ECB for trying to steer global monetary policy makers to stand up to inflation. Yet, the world is not as simple as the ECB sees it I think, and most emphatically, in a stagflationary environment with wide global interest rates pursuing an inflation target may end up being counterproductive. More specifically, the risk is that the stick is bent too far, and the danger is that the end result may be to push an economy like Italy (and perhaps Spain) into outright deflation, in which case all sorts of ghosts about the Eurozone's viability will emerge. Ultimately, the ECB's task is not an easy one and the principal reason is that the bank is not presiding over one homogenous economy; the sooner this fact is incorporated into the policy process, and tools are designed to handle it, the better.