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Friday, October 5, 2007

Is the ECB's Playbook too Thin?

By Claus Vistesen Copenhagen

This I think is the main question in my head following Thursday's meeting in Frankfurt where the ECB decided to adopt and essentially continue the position of holding steady on what is clearly an uncertain outlook. For good measure the original statement can be found here and the introductory statement too. In essence the ECB did what most of us had expected in the sense that the bank is effectively on hold pending future evolution in the credit markets. Of course, this was the rather uninteresting part of the narrative and what really had the markets going was seeing whether or not Trichet would mention the recent upward surge in the EUR/USD. On this note, Trichet fiddled with the same old G7/ECB speak narrative saying that excessive volatility was counterproductive while at the same time (of course) giving no indication of the extent to which he has been following - let alone allowing himself to be directly influenced - by recent skirmishes between various Eurozone presidents (or was it only Sarkozy?) and the ECB.

The overall summary of the meeting is thus a tad difficult to sketch out, and given what I have already said I don’t have that much to add on all this, even if I do think it is worth highlighting a few points.

Clearly, the ECB still sees upside risks to an increase in inflation and, although 'vigilance' was not mentioned, Trichet did go out of his way to underline that the main responsibility at all points in time for the ECB was to ensure price stability. Ok, this is all well and good then but what about the real economy? Here I feel the ECB's narrative is beginning to look a touch overstretched in the sense that Trichet was quoted saying;

``In view of the limited range of new economic data that has become available, particular caution needs to be exercised when assessing the potential impact on the economy,''

Well, I am really not sure what exactly he means by a 'limited' range of new economic data, but there is plenty of data on my desk from the real economy which suggests that Goldilocks has well and truly left the shores of Europe having decided to go elsewhere or perhaps even we could in fact ask whether she was ever there? What I am getting at here is that while the ECB tries to avoid commiting itself by effectively hiding behind the idea that there still is not a sufficient amount of data on which to judge what is going on I, personally, am not so sure. A notable point of departure here could be, for example, the data referred to in Edward’s recent review and preview note here at GEM, where you can find plenty of data pointing towards the recent evolution in the economic environment in the Eurozone and its respective member countries. In addition, we could also mention here Sebastian Dullien’s recent post on Eurozone Watch where he also paints a rather more pessimistic picture of the immediate outlook for the Eurozone, and this is noteworthy given his previously optimistic reading of the situation.

This ties in with another point I think it is important to note, and one which I also brought up in my recent note looking forward to yesterday’s meeting, namely whether the central bank still sees its monetary policy stance as accommodative? Now, a lot of fuss was apparently made in connection with yesterday’s meeting about what in fact this expression really means? Well, in econ 101 terms we usually understand an interest rate being accommodative as meaning that it is fixed in a way such that the economy grows (or is set to grow) above trend and thus harbors a risk of building up excess inflation. Of course there are time horizon as well as overall calibration/equilibrium issues here but let us leave these out at this point. In this way, one of the persistent discourses in the ECB’s narrative throughout this hiking campaign has been that as long as the interest rate remained accommodative there was (quite naturally) room for hiking further. This also needs to be put into connection with the perceived need to contribute to a global process of interest normalization. Yet this also raises the question of what accommodative actually means or more specifically accommodative according to what? Or as Trichet himself puts it …

“Whether accommodative or not, when there are risks to price stability whether we're not accommodative at all we might increase rates,” (…) “What we have to do is deliver price stability.”

This brings me directly to the title of this post and essentially a (brief) analytical assessment of the options the ECB has given its underlying strategy or, if you will, its playbook. In this way, I see a risk that the ECB is boxing itself somewhat into a corner with yesterdays’ statement since it is ever so clear that it will be very difficult to reconcile the objectives of ensuring price stability with those of keeping a straight face (ie not wincing) as economic fundamentals deteriorate and of course as the EUR/USD possibly rises to ever new highs. As an immediate retort you could, of course, argue that the ECB, based on Trichet’s statement’ above, has already chosen its path and that price stability remains the main concern. However, what will happen when push-comes-to-shove here, which in fact it already is I would say. What will the ECB do in the very likely eventuality that inflation keeps nudging up as a result of structural factors (food, energy, and capacity issues irrespective of the business cycle) while at the same time the economic environment, both globally and locally, starts to enter a firm downward trajectory?

This is difficult to say, but one thing should be very clear to all of us: the ECB and Eurozone do not represent a black box, and in particular if we bear in mind the extent to which the EUR/USD cross is driven by expectations of interest differentials, then it should be clear that from a general macroeconomic point of view de-coupling doesn't seem to be working out quite as many expected, at least from the European and Japanese perspectives it doesn't. On this, I would summarize my view in saying that I can understand the ECB’s need to stay with the narrative of focus on inflation but there is also a trade off here. In this way and as I have hinted before, too much focus on price stability and thus a bias to raise or keep rates high even in a context where the Fed is expected to move in the opposite direction opens a huge downside risk to the general growth projections of the Eurozone countries where the hammer stroke especially will fall on Italy, as well as of course on those tightly-pegged countries in the CEE region who will have mighty difficulties following the ECB into whatever distance such a policy will take us. Moreover, there is an underlying and very important point in respect to what central banks can actually do about the kind of inflation we are going to see moving forward? I don’t want to come off as complacent, but if we look at the run on capacity in many countries we need to understand the structural nature of this and why higher borrowing costs might not do the trick. Moreover we have of course the rather perverse effect of all that liquidity which is still bouncing around and which often means that higher interest rates simply tend to suck-in more capital and thus indirectly lead to an expanion in the money supply.

Finally, and before taking my leave, I have a few knots to tie (or whould that be gordian ones to untie?). Firstly we have the likely future course for the ECB given what I have said above. This is still very difficult to call I think since the ECB went of out its way to once again keep all its options open and, as I argue, in doing so it might end up having very little in the way of real options to choose from. A hike is, in my opinion, a virtual impossibility for the rest of 2007 and in this way my formal rate call for this year has not changed. The main question will be whether the ECB will be forced to reduce rates. Fundamentals will of course guide this, but given the current bias towards focus on prices I think the ECB will be wary of making such a move precipitately. In short; they will try to play this one out in Austriche mode with the head firmly tugged in the sand. However, as we have seen since Bernanke chose to face the music and lower rates, the ECB might soon enough be forced to pull itself fairly rapidly out of the sand if it wants to avoid the whole eurozone entering another kind of sandy region, one which contains a quicksand which has, at this point, an unfathomable depth.

The most prominent indicator for all this will be the course of the EUR/USD which is likely to linger in +1.40 territory for the remainder of 2007 if the ECB does not lower rates. Of course if Bernanke does decide to lower again my guess is that that dam will break, but let us not speculate too much at this point. Also, please do note that both the spheres of European politics and business the strong Euro is set to become a major source of strongly voiced concern. For trading purposes I don’t see a reversal in the EUR/USD just yet, but it does seem as if, at least, some of the volatility has abated on the back of yesterday’s meeting which suggests, as I said before, that somewhere around 1.41 would be the current ‘stabile’ place for the EUR/USD. Yet, new and unforeseen events in the US and in the markets in general could alter this very quickly.

Ok, that was it. Between this note, my note two days ago, and Edward's data review (all linked above) you should have a pretty clear picture of what we think about the whole situation from a European perspective. For the future in terms of Eurozone-related content you can expect to see a note on the process of convergence and subsequent Eurozone membership with respect to some of the CEE economies, plus I would very much like to further articulate what I actually think about all that talk about inflation, what it is at this particular point in time, where it comes from and how vould it be effectively dealt with.