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Thursday, July 3, 2008

The ECB - A Token Move or Signs of More to Come?

by Claus Vistesen: Copenhagen

I don't know how many GEM readers are dedicated followers of the day-to-day rhythm of market movements but with an important US unemployment report and a much awaited ECB interest rate decision to think about I imagine that many a trader and broker spent a good part of last Thursday holding their breath. In the former case the data confirmed that the US economy is stuck knee deep in stagflation as unemployment held stubbornly at that 5.5% "statistical quirk" while payrolls registered the sixth consecutive month of job losses, shedding 62.000 jobs. If the latest US employment data may have raised an eyebrow here and there, the decision taken by Trichet and his governing council almost certainly will not have (introductory statement here) since the 25 basis point hike was more or less expected by everyone.

As I suggested earlier this week the quarter point increase was never really in doubt, and attention was focused on the extent to which Trichet would use the opportunity of the "pre-announced" increase to lock market expectations in to an expectation of further rate tightening. Personally I was always skeptical about this possibility, and in particular given the numerous off the cuff commentaries emanating from members of the governing council that 4.25% constituted some kind of magic nominal rate to anchor inflation expectations. Yesterday's accompanying statement from Trichet only serves to confirm this view. Trichet and his team have opted for significantly toning down any prospects of future rate increases, at least in the short term. Certainlt this was how most market particpants chose to interpret the contents of the post meeting press conference, and the EUR/USD headed back towards 1.55 rather than upwards towards the 1.60 mark. You can see the longer term evolution of EUR/USD in the figure below where a value of 1.60 would correspond to an index value of 117.2

So many a long EUR/USD punter was handed a rather sharp thump in the lumber region today while their counterparts perched on the other side of the fence got some much awaited relief. At this point it is by no means a sure thing that 1.60 may not return to the table, but if the ECB lays down the whip for now I think such a move is unlikely (which, judging by my earlier attempts to call the EUR/USD this year, probably means that it is very likely).

Trichet in the Sweetspot?

Wait a minute then. Doesn't this mean that Trichet got exactly what he wanted this time around as the EUR/USD dipped alongside a rate hike? This may be the case and while I am a firm believer in not attaching excessive importance on the strength of correlations the chart below does quite neatly sum-up the ECB's present dilemma (as well as does the growing divergence between core and headline inflation as I explain here).

Perhaps I am being a little sloppy in chart construction here - since the dates don't match exactly - but then again, the point I am making is hardly rocket science. It is important to remember here that the increase in headline oil prices is absolute even if of course the appreciation of the Euro itself lowers the relative price. As Macro Man so succinctly pointed out at one point, it is exactly this issue (or the neglience thereof) which makes nominal inflation targeting such a dangerous business. Put another way, we could follow Barry Ritholtz's lead and dub the surge in crude oil prices the "Trichet Rally."

Readers could be perhaps rightly be accusing me of criticizing the ECB unjustly here. A flip side to this coin would then be to interpret the ECB's move solely in the light of anchoring inflation expectations. In such a minimalist framework - neatly skinned of such "flabby" concepts such as neutral interest rates, output gaps etc - the main thrust would seem to be that inflation is largely a reflection, not of movements in monetary aggregates, but of what people believe it is going to be in the future (but over which horizon?) and of their ability to enforce those expectations on their employers or customers.

Whatever the ultimate validity of this point of view, one thing is for sure, and that is that the recent surge in headline inflation has produced a sharp spike in inflation expectations even if investors seem, at the same time, willing to accept the credibility of the Fed's inflation fighting intentions, at least as judged by the yields they are willing to accept on US treasuries.* In this light the ECB is neatly fielding the ball across and into the court of BOE and the Fed by signalling the need for a collective response in providing a credible commitment to flush out global inflation. To add further to their shoulder padding, the ECB recently got some strong indirect support from the BIS's 77th annual report (see also Brad Setser), which elaborated in great detail on their view that it is excess liquidity that is the main source of the global economy's ills.

Of course, there can be little doubt that since a significant part of the current inflation spike is global in origin, then a credible response to inflation will entail some kind of global monetary policy response. The ECB cannot fight this one alone and as I have argued over and over again inflation targeting in a world where investors follow yield carries great risks of being counterproductive.

But how likely is it that we will see such a response, and assuming we do, what would it look like? If a significant part of the pressure on global energy and food supply-side resource constraints comes from pressures which ultimately originate in rapid growth in BRIC-like emerging economies how can monetary policy within the OECD help. Doesn't slowing growth further in the developed economies only run the risk of sending even more funds off to the emerging markets in search of yield? And, just how realistic (or fair) is it to ask citizens in what are, after all, largely poor countries, to use monetary policy to restrain their growth simply because our shoes are now starting to pinch.

Clearly, the BOE and the Fed seem, at the present time, to be pretty reluctant to follow the ECB's best foot forward, and while many emerging markets are beginning to tighten the reigns the USD pegs remain and so does Japan's near ZIRP interest rate policy. And of course even further monetary tightening in those emerging economies which are feeling the full force of the inflation pressure can have rather perverse effects, as, for example, in China, where reserves seem to have jumped by around $75bn in April and $40bn in May (to a total which is now reckoned to run at something over $1,800bn) on the back of expectations for further rate rises and currency appreciation.

Another point worth making here would be that, while I fundamentally agree with the BIS that something needs to be done to rein in global inflation, the risk of provoking outright deflation in some key low growth OECD economies is non-negligible should the slowdown be too sharp . The key here is the link between the idiosyncrasies of national demographics, internal consumer demand and thus the differential abilities to pull the local economy out of any trough it may fall into. We should remember that the world is ageing and in some corners with an unprecedented speed. In fact, my own and others' research suggests that the turn of the 20th century has seen the importance of persistent low fertility in OECD and key emerging countries spike dramatically. Quite simply, it increasingly seems to be the case that fertility does matter and especially, with a lag of 30+ years of below replacement fertility.

A detailed argument will have to wait for another day but what I am suggesting, is that if we are not all careful the world could end up with a number of "Japans" on its hands after all of this is over, and that would especially be the case if monetary policy makers became set on administering a strong dose of anti-inflammatory medicine. This is not an argument for not taking inflation seriously and acting upon such concerns, but it is one for thinking seriously about the possible consequences of your actions, since a bad outcome could mean, for example, confronting the Eurozone with an Italian economy which will never be able to repay its government debt. In a global context what we may well find is that a growing number of ageing economies emerge from the present downswing as being totalyy dependent on export growth to achieve headline GDP growth, and I am sure that it is not too difficult to see how this would present a problem in and of itself in terms of finding the countries ready willing and able to accept the deficits which will be necessary to balance the global books.

More to Come?

But possibly I am getting ahead of myself. What about yesterday's move by Trichet; will it be the first of many or simply that famous token move it has already been dubbed? Given my continuing scepticism towards the ECB's one page playbook and my previous comments it should not surprise readers to learn that I believe this will be the last such move for the foreseeable future (see also Aurelio Maccario). As always with ECB speak, one could easily interpret Trichet's statement as containing an inbuilt option to raise rates as and when it is deemed necessary. What I really think though is that the ECB's stance will be really contidioned by the slowdown in the German economy which will probably make itself felt later this year. Given the probability of such a scenario, and with the entire zone slowing, I have a difficult time seeing from where exactly the ECB is going to be able to must the strength to lift rates again significantly.

So what about that reduction in interest rates which investors had such high expectations for as we entered 2007? The ECB will fight long and hard to avoid such a move in 2008 I think, and in fact, given the likely downward rigidness of headline inflation (this is structural remember), the Eurozone may be entering whatever comes next with a central bank unwilling to ease monetary policy in any significant way. This may well be the assymetry we have, at least until their is a significant shift in attitudes in Frankfurt.

Over at Bloomberg Simon Kennedy cooks up a neat story in which the ECB's strategy is narrated as pre-emptive damage control. I am willing to go with that narrative. However, today's move may still turn out to be a swan song for the ECB's credibility (as Sebastian pointed out here) even if this was exactly the underlying reason for the decision. The risk we face then is not so much one which comes from the adverse growth effect of the 25 basis points increase itself but rather that the ECB finds forced into reverse gear far sooner than it would like to. This could make today's events look rather a sign of weakness than one of strength even if they do, at this point, paint a picture of an ECB firmly situated at the helm of global monetary policy. As ever, history may well show a tendency to be rather less than flattering in its ultimate judgement of those who would steal the show in the here and now. Unlike good wine, age, I fear, will ultimately weary them.

* Personally, I think that the whole discussion of the yield curve is in badly need of a dose of the good old segmentation theory which I believe would go along way to explain why in fact emerging economies are willing to continue financing the US. I mean, it is pretty damn obvious that they are not buying T-bills for their real return, isn't it?