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Monday, April 14, 2008

The ECB - One Play-Book, One Page, One Purpose

By Claus Vistesen Copenhagen

Last week was certainly something of an eventful week was it not? Three central bank meetings and a G7 gathering to top it off even though the latter spectacle of course was somewhat of a 'non-event' as per usual. Some anxious investors were expecting scant signs that the G7 group be inclined to actually do something about the Buck's fall from grace; they are bound to be disappointed. As so often before we got a lot of talk but very little walk and in the context of the G7 group we know from the past that talk usually is very cheap indeed. Evidence so far from today's trading session confirms this as the EUR/USD has not moved substantially from its high ground at about 1.57-1.58. Naturally, if the G7 finance chiefs were secretly knitting together a new Plaze Agreement 'in reverse' they certainly would not be flagging it in a general statement since this would create more of that volatility which the group tried to quell in the first place. Macro Man also muses on the potential effects of the G7 statement and even takes us on a trip down memory lane and past high strung statements from the group in the context of historical events of intervention in currency markets. In essence, this is all very difficult to tell.

Turning more specifically to Europe and what I really wanted to spend some time on we had two interest rate meetings last week; one in Frankfurt at the ECB (Q&A here) and one in London at the BOE. The formal results of these two meetings were completely as expected. Trichet and his governing council maintained the rate at 4.00% whereas Mervyn King and the BOE acted on a series of abysmal economic indicators, not least from a visibly collapsing housing market, to lower the benchmark rate 0.25 basis points to 5.00%.

Consequently, and since I have been promising lately to comment on the Eurozone, and also what to do with that swiftly depreciating prediction of a rate cut in Q2, allow me to elaborate a bit on the economic outlook in the immediate context of the ECB's recent decision. Regarding the actual decision to keep interest rates steady this was not at all surprising. However, what was perhaps a bit interesting (since it was not particularly surprising) was the statement delivered by Trichet. As per usual, both the lingering inflation and real economic risk were emphasised. What was subsequently interesting in this respect was that Trichet, while highlighting both in equally strong sentences, explicitly noted that the ECB would focus on the former. Alas, not much relief for investors hoping to cane the Euro, which at this point in time is still at very high levels not least against the GBP following the move downwards by the BOE. As is well known at this point, the main headache for the ECB is the fact that just as the credit turmoil began back in August so did inflationary pressures thus highlighting the current nature of global 'stagflation lite.' Let us take a visual inspection...

The three figures above pretty much sum up the predicament in which the ECB is situated. The figures also raise the fundamental question of what exactly should be 'defined' as inflation in a context of setting a specific inflation target and then follow this target through some version of a Taylor rule. The ECB's internal discourse here seems a bit inconsistent. As such, Trichet himself conceded in the Q&A session last Thursday that commodity prices and food prices cannot be controlled or fixed from within the realms of policy. Yet even so, the ECB remains fixed on this gauge as the main metric on which to conduct its policy. This is however not so difficult to understand. The ECB has repeatedly been pointing to the fact that their main worry would be for long run inflation expectations to shoot up where e.g. second round effects from wage negotiations have been mentioned. I don't see many second round effects though. In fact, if we look at German inflation measured ex energy, food and tobacco it has actually fallen in the first months of 2007 suggesting that whatever kind of inflation dynamics observed at the moment in Germany it is not driven by domestic demand and credit developments. Moreover, this discrepancy between a core index including headline inflation and one excluding is not without precedence. Japan has one too and if there is one thing Germany and Japan have in common it is a median age of about 43 years. This is not likely to persuade the ECB though and if we turn to monetary aggregates the M3 is still running well above target. I have on many occasions questioned the validity of this measure, especially since the nominal rate required to reign in monetary growth measured by the M3 would almost definitely imply deflation in the core price index. I should not be coming down too hard on the ECB however. As I have said before this is a dilemma if there ever was one but I am still inclined to think that the ECB is moving into dangerous territory.

What remains then is the fact that the ECB is playing a high stakes game in its conviction that what currently represents excessively high inflation will linger. The reason I call this high stakes is that not only do we need to watch the main HICP reading but also the extent to which the indices of core and headline inflation diverge. In general, the ECB's assumptions applied to conventional economic tools of the 'neutral' policy rate consistent with trend growth and inflation pressures run the risk of prompting policy makers to act too harshly on the short end of the curve relative to what you think is an arbitrary long run implication of current events. An example of this would be Joachim Fels' and Manoj Pradhan's recent analysis over at Morgan Stanley's GEF;

In the euro area, our estimates also suggest that monetary policy is expansionary, though only moderately so. Three-month Euribor, which we use in our model instead of the ECB’s refi rate, currently trades at 4.75%, or 75bp above the refi rate. However, with HICP inflation at 3.5% in March, the real three-month rate currently stands at 1.25%, lower than our estimate of the neutral real interest rate of slightly less than 2%. Thus, apart from the short spike in 2H08 caused by the liquidity squeeze in the interbank market, euro area monetary policy has been expansionary on our measure for most of the past six years. It should hardly come as a surprise then that inflation in the euro area is running significantly above the ECB’s comfort level.

This is a very dangerous application of conventional economic analysis and one which goes to show that the idea of a neutral real interest rate should be taken with a pinch of salt. At all points in time it takes time for movements in nominal interest rates to work their way through to the real economy and in this period short term inflation movements may deviate significantly from an ex ante assumed long term equilibrium level. Moreover, I am even more unsure about the validity of Morgan Stanley's analysis in the light of the current inflation dynamics where indicators show that the pressure from headline inflation is coming as a backdrop from structural and speculative demand shocks in the context of emerging market demand for commodities (e.g. food and energy) and investors' movement into commodity futures to benefit from the former. At the very least, we should be weary of denoting the ECB's interest stance as accommodative if we are moving into some kind of stagflationary environment. The danger that some of the Eurozone economies experience a slip into deflation cannot be ruled out at this point and we know, once again from Japan, how difficult it can be to escape; especially if you’re labouring under the yoke of a structurally broken population pyramid. In this respect the rise of the Euro becomes a double-edged sword. On the one hand it helps as a shield from the pressure of headline inflation by making commodity and energy imports cheaper, but it also makes everything else cheaper (i.e. imports) or put another way; It is deflationary. Consequently, and given the fact that the ECB may potentially leave interest rates higher for a prolonged period it could be what pushes some of the member countries into deflation. Lastly on the Euro, we also know how the current movements in currency markets are exacerbated by the relentless hunt for yield on the short end of the curve which can, in the short run, cause the Euro to overshoot even stronger than it has already.

As such, the ECB's focus on inflation comes in the context of a Eurozone wide but also asymmetric slowdown within the realms of the real economy. For those of you who have been following the writings at this space this is not a surprise. Ever since the credit turmoil began and it became clear that the Fed was going to lower rates I have been persistently arguing two things. First of all, that the process of de-coupling à la traditionelle by which the Euro takes over from the Dollar is unsustainable but also that the incoming slowdown, although bound to be widespread, would lie bare the asymmetries inherent between the Eurozone’s economies. These two processes are of course not independent since by very nature the former exacerbates the latter. What we are currently witnessing is consequently, in all modesty, very much along the lines of what has been sketched here at this blog. Obviously, I have not gotten it all right. For me the continuing stalwart showing in Germany is a surprise but the nature of it is not in the sense that Germany remains to be driven by external demand. In a cyclical correction where all main fault line cuts across economies with widening external deficits it does not take an economic literate to see that the show has to end at some point. For a concrete take on the most recent cyclical developments in the Eurozone I recommend you to visit the space of Edward's and my aggregate collection of Eurozone watch blogs. Particularly the following on the Eurozone service and sentiment indices is a worth a look for a general overview. As for concrete forecasts and the immediate outlook the consensus is nudging the timing of potential ECB cuts further out into the horizon. This seems to be prudent from an investment point of view. As Elga Bartsch from Morgan Stanley noted recently the ECB is still not satisfied that corporate capex and credit developments are vulnerable enough to merit a cut in the refi rate. I tend to think that these signs to some extent are already here but as Stephen Jen said in another context Germany remains the key economy to gauge. Once activity start pointing decisively down here the ECB will slowly begin to correct. Lastly, we need to remember that the ECB, like the many other central banks, have indeed been busy flexing its liquidity muscles in the interbank market by lending to banks and financial institutions.

Apart from the well-known narratives of de-coupling and global re-balancing the ECB's current lingering policy stance also recently shored up in a debate about whether in fact the ECB is rather helpless faced with the growing divergence between the economies over which it presides. As such, we could do a lot worse than visiting the FT's Ralph Atkins and his recent weather forecast for the Eurozone economy which neatly underpins the discourse I emphasised above on the growing asymmetries between the Eurozone countries. Especially Italy, Ireland and Spain are now slowing fast as well as many Eastern European countries, of which Germany depends to export, are now dropping like stones. Meanwhile, France and Germany seems to be holding up respectably well even if the general rate of momentum has gone down. Coupled with the picture derived from inflation above it certainly does not make life at the ECB any easier. Yet, as Atkins points out at the end of the piece...

Within the eurozone, the ECB’s main concern will remain the region’s worryingly high inflation. In practice, there is not much it could do itself about divergences anyway, given its supranational responsibilities. Mr Barrie says: “The ECB will look at what it all adds up to, rather than where it is happening.”

That sounds about right to me and also follows directly from what we heard from the ECB last Thursday. However, as I have been arguing, the development which started last summer as the interest differential between the ECB and Fed began to diverge were also bound to move us into the ongoing discussion of what exactly it means to have a one-size-fits-all interest rate policy in the context of the Eurozone. And indeed the discussion has begun. Recently, I moved in with a comment to a piece by Avi Tomkin in Forbes in which he sported the ridiculous claim that the Eurozone would cease to exist within three years. I obviously disagree but, as I also said, I do think that the discussion does have some merit since after all, as Tomkin also notes, the Eurozone is an experiment rather than a proven structure. Well, the Economist's Free Exchange is not so sure and their response to Tomkin involves the very reasonable point that the Eurozone operates with a tremendous lock-in effect. In this way and although Spain, Italy and others may be discontent with the way ECB handles its affairs it would surely be even more of a debacle to actually exit the zone. I only conditionally agree. Clearly, exiting the Eurozone would not only be a financial challenge, it would be a veritable crisis. However, what is missing in the overall discussion is the potential alternative. Charlemagne, the Economist's European commentary correspondent, eloquently pinpoints the political issues in this week's edition of the print edition. There are consequently two important issues here. First of all there is an obvious bias inbuilt in the ECB's tendency to look at aggregate data as Germany carries a larger weight in the models deployed. This is not strange in itself but when we observe divergent tendencies it becomes a potential political problem. The second political problem presents itself on the basis of what we are seeing in Spain. In this way it was always the idea that the Southern European countries would converge to a growth path akin to the rest of their European peers as a result of having been included in the league of the common currency countries. Now, as Spain looks set to suffer a severe downturn the experience looks set to pan out as anything but the one prescribed. Consequently and after having enjoyed 6-7 years of unprecedented growth rates Spain now seems set to move over to much more lackluster times. In this way, Spain seems to have gotten exactly the opposite from the ECB than what economic theory prescribes. Low interest rate in the context of a construction boom and a massive positive shock to the labour market, and now when relief in the form of lower interest rates could perhaps be warranted they are not likely to get it. This kind of boom/bust tendencies is not going to down well with potential future members from Eastern Europe. However, the real potential crisis in the context of the Eurozone still comes from Italy. As Edward magnificently details at great length in his most recent note over at GEM Italy is now set to enter a recession. This will mark the fourth recession in Italy in the past 5 years and the longer this goes on, the higher the tensions will built. At the core lies two crucial points. Is it viable or even wise to expect Italy to suffer a prolonged period of deflation in order turn the ship around? I think not and my reasoning is quite simple since we know that once a country with Italy's profile slips into deflation it may be extremely difficult to escape. Furthermore, it would be practically impossible for the ECB to practice some kind of a contained version of quantitative easening in one member country. The Eurosystem does not allow this. In fact, and this relates to the second point, the Eurosystem's structural pillars themselves run the risk of creating the financial crisis we all want to avoid by seeing one or more countries leave the Eurozone. Here I am not talking about the Maastricht convergence criteria which have steadily cruised into insignificance as it became clear that none of the big member countries could abide to them. Rather I am talking about the technical point that the ECB, back in 2005, provisioned that it would not accept government paper with a debt rating below A-. In Italy's case this is important since the rating agencies are keeping more than a weary eye on Italy, its y-o-y budget deficit and public debt. Rules are of course meant to be re-made, or as in the context of the Maastricht criteria, neglected all together. But this all goes to show what kind of predicament we are dealing with and why this a bit more complex than just referring to the 'lock-in' function of the Eurozone.

Yet, what does the ECB actually have to say about the growing divergences between the Eurozone member countries? Well, luckily one reporter asked that very question last Thursday during the Q&A session. And the following was Trichet's response;

We are, at the level of the 320 million people of the euro area, in exactly the same situation as the Federal Reserve is with 300 million people or more. We both look at the economy as a whole. We have a single economy with a single currency and we have differences. You mentioned a number of countries: Ireland is certainly a country which is not necessarily at the average of the euro area, just as California, Florida or Alaska are not necessarily at the average of the US. When we take a snapshot of the situation today in the US, state by state, and in the euro area, country by country, I would say that we have approximately the same standard deviation of inflation and of rate of growth. This is what our own research, which has been published and confirmed, has shown. So you have to take this into account. The Governing Council looks at the continent as a whole, from Helsinki to Lisbon, from Nicosia to Dublin, from Malta to Ljubljana – these are the geographic dimensions of the continent which is a single economy with a single currency.

I know that this is what our good governor has to say at a press conference like this but I also have to say that it disturbs me a bit. It disturbs me first and foremost because if this is really the prevailing view within the governing midst of the ECB I think they are in for a grave surprise. Also, the comparison with the US made by Trichet smacks of ignorance even if the allegory obviously sounds alluring. Please note that the point about similar standard deviations of growth and inflation is completely irrelevant here since the differences in political, social, and demographic construction between the EU and the US makes this comparison akin to comparing apples and ... well French fries. In short, I most emphatically disagree with the governor on this and I think that unless the inherent divergences within the Eurozone are accepted, the result is not likely to be pleasant. This also goes into the heart of the discussion above about what exactly the ECB should be targeting. Price stability remains the main mandate and I hardly think that anyone can disagree with this but the ECB is not your average run of the mill central bank and the EU is not (yet) a federation. I want to emphasise that I am not joining some kind of dooms cult preaching the inevitable demise of the Euro but when I read Trichet's remarks above and subsequently peer out into the real economic edifice of the Eurozone I am amazed by the discrepancy between the two.

In Conclusion

Immediately, I should apologize to my readers. The note above is thus a terrible mix between objective calls on the course of events in the real economy and somewhat more normative assertions and opinions on the ECB's policy. In this summary I will make amends and clearly make a distinction between the two.

In terms of the immediate cyclical developments in the Eurozone economic growth is now visibly slowing in key member countries. We are far from a zone wide recession or stagnation but divergences are growing. In both Italy and Spain we are thus witnessing significant slowdowns. In Spain, the housing and construction sector is now correcting rapidly following half a decade's worth of unprecedented growth. This is having a very clear effect on domestic demand for both services and tangibles. The slowdown in Spain is actually rather important in terms of gauging the overall trend of the Eurozone. As such, the past year's aggregate Eurozone growth rate has to some extent been propelled by Spain on the margin. It will be interesting to see the impact once Spain moves onto a path with a slower overall pace of headline GDP not to mention what happens in the immediate context as Spain may even be flirting with a recession in Q3 and Q4. Italy on the other hand is likely to have entered a recession already or at least we need to consider this as a distinct possibility. We don't really know at this point since Italy conveniently did not publish GDP figures for Q4 but given the estimates knocking about as well as the monthly readings throughout Q1 I would not be surprised to have seen two quarters of negative growth in Q4-07 and Q1-08 or at least very close to stagnation. Meanwhile, further to the north the two other of the big four in the Eurozone are fairing somewhat better even if the outlook is cloudy. France continues to jog along driven by solid domestic demand. Germany, on the other hand looks more vulnerable even though she is growing at the same pace as France. However, as per usual it all about external demand and given what we know about German exports and their dependence on Eastern Europe I don't expect Germany to run on this kind of steam much longer. However, I also concur that it will take some clear signals from Germany in the form of both deteriorating sentiment and real economic data for the ECB to move in at this juncture with inflation running at current levels. In this light, my call for a rate cut in Q2 (i.e. in May or June) now seems decisively out of tact with reality. I am still, however, not ready to take it off the table in terms of a potential move in June but at this point I should advice that this is very much out-of-consensus. Data from Germany needs to take a sharp turn for worse in order for this to materialise. For the moment inflation continues to be the main driver of policy setting at the ECB. An interesting topic in this respect will be how the ECB reacts to the widening spread between headline and core inflation in key member countries.

This brings me to the more normative nature of the note above. I consequently emphasised how the incoming slowdown in the Eurozone is likely to bring forth all kinds of ghosts with respect to the nature and merits of the single interest rate policy. Trichet clearly sees the Eurozone as one single economy. I don't and I think the ECB may end up in a rather tight spot (if it is not already) given its reluctance to hone up to the fact that it is not in fact presiding over a homogenous economy. The key point is not to put a date on the implosion of the Eurozone which is obviously not very likely but I do find it rather important to look at the evidence presented to us in stead of just sticking to a one-page play book while at the same time reacting to a global financial crisis and global currency correction by acting like the proverbial ostrich.