The ECB - Walking the Walk?

As the proverbial end of the road nears for the ECB and the July meeting it is as if the market divinities have been trying their utmost to penetrate the ivory tower in Frankfurt. Of course, I am not sure that my readers have been sticking their heads into their Bloomberg terminals with the same vigour as I have, but I can tell you that the past week's news from the Eurozone has been devastating. Now, if you are confused I can understand. I mean, was this not exactly the point with the ECB's hawkishness in the sense that it would jolt the Eurozone economies to such an extent that inflation would squirm back below the 2% mark? Indeed it was but as I have been warning several times, the asymmetric nature of the current slowdown and ultimately its severity across the entire zone makes this a very dangerous policy choice.

On a completely different note the editors of the RGE's European Economy Monitor have extended me an offer to contribute to their group blog. I could not, of course, decline such an offer to rub shoulders with the likes of the scholars contributing (just look at the roster). In this light, this installment of Eurozone Watch has temporarily shifted venue. I should assure my readers that this will not become a trend, but since the points and arguments resemble the ones made in my most recent post here I thought that I would field it over at RGE. Here is my summarizing paragraph:

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 be that 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.

Comments

[Chirag]

I quite agree that ECB has no option but to increase interest rates. But ECB being such a large bank in Europe will also trigger interest rate hike in US. Fed doesn't want it particularly because the moment interest rates rise, dollar value increases - thus decreasing posts. This in turn, would shoot up the current account deficit. Furthermore, it will push up the payments to be made by homeowners on their mortgage accounts.

[CV]

Hi Chirag,

Thanks for the comment ...

The scenario you describe may of course happen but I am not so sure that the Fed will be bullied by the ECB into raising rates. The key here would be the extent to which the other central banks were able to muster a universal credible threat (i.e. count Japan out).

Remember your point on the CA deficit ... it is exactly what the US is trying to escape so for the moment Bernanke is happy, I think, with not giving a rat's a** about the USD. Inflation could of course very well force his hand and it may well be the case. In this case though it will definitely only bring us close to the past with the 'old' BWII system.

The balance act for the ECB is that they are trying to run inflation targeting in a world where such a policy contains so many externalities and feedback loop effects which may end up hurting key economies in the Eurozone.

Claus