Well, well, the plot thickens does it not? Certainly yesterday's more than strong hint (introductory statement and Q&A session here) that the ECB will raise rates come July is a clear sign that central banks are not at all sure about what to do. Some are revising up their inflation targets, some are searching for an output gap to justify why rates should be kept lower than the current and rising double digit chiffre, and some again are contemplating whether in fact a strong currency is the right remedy in the current context of stagflation. Ah yes, the wonders or more precisely perils of inflation targeting in a world of stagflation and excess liquidity on a relentless hunt for yield.
Within this patchwork of central bank decisions you could argue with some reason that the ECB, of all the rugged participants and tarnished knights, have managed to steer clear of dragons and ghosts with more elegance than its peers (I still think that a behemoth lures around the next corner though). The market discourse certainly seems to be riding this wave at the moment or at least some parts of the punditry is. Consequently, Trichet was branded with the label of 'leading the shift from growth to inflation' amongst global monetary policy makers in a piece by Bloomberg Friday morning. I am not sure the ECB and its governing council would admit to be leading anyone or anything but it is undoubtedly true that the market focus, as of late, has shifted from growth and credit turmoil to inflation. And within this shift the ECB's hawkish stance has clearly been solidified. Ultimately and initially it is in this light that I think the ECB's decision to dip its toe at Thursday's meeting should be seen.
However, as a dear econblogger of mine likes to point out; history does not repeat itself but it rhymes.
It would thus be a good idea to step back and look how we actually got to where we are today. This is obviously a rather open and cryptic question but in this context I am specifically talking about the Spring of 2006. Back then it was widely held in the market place that the G3 central banks led by Greenspan, Trichet, and Fukui would embark on a joint hiking trip to mop up excess liquidity. And so they did. The BOJ ended ZIRP and both the ECB and the Fed also commenced a tightening cycle in an attempt to normalise interest rates. Yet, the rest as they say is history and whatever we think would be a 'normal' interest rate it did not really go as expected. In Japan the continuation of deflation has kept the BOJ from raising more than 50 basis points, in the US a housing crash prevented the Fed from keeping interest rates at 5.25% for long before they were slashed and in the Eurozone the ECB's tightening cycle ground to a hold. One reference frame in which to slot the current situation would then be to ask whether in fact the ECB is trying to recall its peers to the hiking trail and whether it will be successful?
In this regard, one thing is certain; the ECB is not leaning so much against the wind this time around in its adamant and lingering focus on inflation. What the ECB is leaning on however is a rapidly slowing economic edifice which is only brightened by an outlier in the form of the Q1 GDP figures. Other than that, the economic news from the Eurozone leading up to Thursday's pre-announcement of a July raise has not made for pretty reading. For a complete overview I am directing you to me and Edward's aggregate Eurozone Watch blog as well as Edward's latest post on Spain over at GEM. But do take a look at the following list of news points and; German industrial production down in April, Eurozone retail sales down, aggregate services indices recording stall speed etc. On this background the ECB is obviously playing tough in its focus on inflation over economic fundamentals and once again trying to emphasise the need to get inflation back in check regardless the collateral damage.
I have argued several times that it is far from certain the higher interest rates can quell inflation in a world where excess liquidity goes for top line yield. Moreover, and as Macro Man is bend hell on hammering down lately the exercise of inflation targeting itself may essentially be impossible or in fact counter productive since raising nominal interest rates will only suck up even more purchasing power and as such act as a magnet for the global flow of funds. Yet, this need not be a problem for the ECB as such (for the countries in EMU perhaps?) but it requires that others are in on the idea that rates should go up. Otherwise you end up with a lot of action but very little effect which may even end up being counter productive. Remember please here that if the ECB is serious here it could with all likelihood take the EUR/USD upwards towards 1.70 and this is not accommodative for easing inflationary pressures. The point here is that even if imported inflation goes down oil, energy, and food will still rise much faster given the current market dynamics. In this light alone I do think that the ECB is playing a very high stakes game here.
Another theme I have been following is the distinction between core and headline inflation. Interestingly, it is precisely this distinction which has grown quite unfashionable as of late and which recently prompted the Fed chairman Bernanke to voice concern about rising headline inflation not to mention the flurry in Eastern Europe about revaluation, a Brazilian rate moving towards 15% and now an ECB reverting to its hitherto hawkish path.I still think the graphs tell an important story. First of all it goes without saying that inflation indeed is far above the 2% threshold set by the ECB although the increase seems to be reaching one of those famous plateaus. The increase in core inflation however is coming down across all big four Eurozone countries and the 1.1% estimated in Germany for April is not exactly wheelbarrow territory I would think. In fact, the evolution in Germany is beginning to look curiously like the one in Japan with core inflation heading towards deflation and headline creeping ever upwards. Nothing 'unexpected' (you gotta love those Bloomberg headlines) here however since if we think about the demographics of these two countries it is not so difficult to understand which also means that when exports falter in Germany the real action begins and in this light I am waiting with much excitement to see how credible the ECB's commitment, not to mention our dear Mr. Weber's, really is.
I continue to hold the position that the ECB is embarking on a very dangerous path here since what goes up usually comes down. Here I am not talking about headline inflation in particular but rather about the dynamic by which the ECB may be forced, on the backside, to hold interest rates much lower for much longer to accommodate the mess which is about to unfold in the Eurozone. Of course, such a strategy might not be chosen but I just don't see anyway out of the fact that EU27 now is slowing considerably both in real and potential figures. In general, it now seems that with Spain falling the only real domestically driven economy in the zone is France with the rest of the gang either already, in the context of Germany, or attempting to become, in Italy and Spain, export driven. In such a context it does not exactly make sense to raise rates to become the new global consumer of last resort which I think we can all agree is quite out at this point. Another point I have been emphasising is the Eastern European connection. Admittedly, this is not something which the ECB is forced to, let alone obliged, to take into account but it is nevertheless important. Basically, we need to understand that at the moment Eastern European countries are not only struggling with rapidly overheating but also slowing economies all at the same time as many are nominally pegged to the Euro. Any hiking campaign by the ECB is likely to further put the squeeze on CEE economies and not only the peggers since one can easily concur, I think, that if the ECB hikes countries such as Hungary and Ukraine who recently loosened their pegs will have to follow the ECB if their currencies are not to plummet. If we think about this for a moment I actually do not think it would be entirely uncalled for that the ECB take this into account or at least that it came out with a clear message to those Euro members in spe still struggling to keep up with the yoke of convergence demands.
A Credible Threat?
So, where the hell do we go from here? In my Industrial Organization installment at the Copenhagen Business School they tried to teach something about credible commitments in the context of game theory (you know, those decision trees). I think it is reasonable to ask whether in fact the ECB is serious here? It would serve us to remember that last time we got a pre announced raise back in August 2007 it was shelved due to the breakout of the subprime crisis. In the current market context it is not difficult to imagine that such an event may occur yet again. However, somehow the ECB remains more sturdy this time around and it would be unwise not to expect a raise come July. There are many ways in which to see the ECB's sudden reversal. Personally, I actually do think that the ECB is trying to steer global monetary policy makers and not least the Fed into re-igniting the hiking trip which was begun back in 2006. In this context of course there is the little problem in Japan where I feel rather certain that the new governor would be more than a little bit weary to re-embark on such a trip at this point. Moreover, we also have the small detail of who exactly is going to shoulder the new Bretton Woods II (or III?) edifice if China and the petroexporters do not budge. Surely, India, Turkey and Brazil are doing their part but a stronger USD at this point would also increase the purchasing power of US consumers thus risking to bring us right back into the mess.
No easy solutions here it seems and consequently I remain skeptical of the ECB's ability to follow through here. The key for me is the extent to which the ECB will raise into what is now obviously becoming a German slowdown too. How will Weber for example act when it becomes clear that the German growth spurt for all intent and purposes ended in Q1. This also brings us to a wider question which I have asked on may occasions. How much should the ECB raise here? Clearly, a 25 basis point token move only to see the economic edifice crumble around it would leave the ECB rather pathetic I think. Is the ECB really serious here then? Over at Eurointelligence a move to 4.5% is being pencilled in but clearly that would not be enough, now would it? And while I know that we are still missing those markets I suggest that we go about and find them or more appropriately realise that inflation targeting is not as effective as the textbooks prescribe.