Yet, the curtain may soon fall for the ECB as economic realities impinge on the objective to maintain price stability. It is pretty obvious that Spain, Italy and Ireland are now all three slowing rapidly. This is not necessarily bad in the context of Spain and Ireland where almost a decade worth of brisk growth had to come to an end but in the context of the former the boom/bust dynamics look set to become very severe indeed. Furthermore, Italy is now set to painfully conform to all those claims heralding the country as the sick man of Europe. I still think that Italy represents a risk to the stability of the global financial system which is wholly unpriced into the general market movements and it is precisely in this context that I have been rather critical of the recent six months' rally in the EUR/USD. However, in terms of cyclical observations it has long been clear that the ECB would not move unless material evidence of a slowdown in Germany emerged. Domestic demand has long been stagnant and declining but that has been countered by an impressive growth in exports and as a derivative industrial production (corporate capex). In this light, the recent news that both exports and industrial production declined in March is not at all insignificant (neither of course is the corresponding news from France).

The ECB is not likely to lower rates come next meeting in June. For this to materialise we would have to see a significant turn for the worse in terms of German data as well inflation also should show signs of abating. On the former account I think we might very well see a considerable deterioration (see also Sebastian Dullien here) although April compared to March is likely to show a pick-up. This is mainly due to the fact that if you add the numbers for March only the PMI for services showed a slight expansion. This means that Germany may have contracted in March. This will of course be verified once we get national accounts for the Eurozone but it is clearly significant in terms of those aiming for a growth rate of 0.75% in Q1. The EUR/USD is now hovering a tad bit lower than its previous highs of 1.59-1.60 currently trading at around 1.54-1.55. The reasons for this slight fall from grace could be many but most prominently has been a discussion about whether foreign central bank reserve managers sold out a bit at 1.60 seeing that the main source of the global economic instability was the falling USD and its contribution to global inflation; much more about this here as well as at Brad Setser and Macro Man.

In summary, the ECB retains its inflationary bias in the face of growing and lingering headline price pressures. The dilemma however has not gotten any smaller in Frankfurt where the ECB is now presiding over a stagflationary economy with notable divergences between the member states. In all likelihood the ECB will stay pat come next meeting in June. A below consensus Q1 GDP reading, a material slowdown in Germany, and abating inflation pressures could pave the way for a cut already in June. This is very unlikely at this point though. Conversely, if inflation picks up considerably pushing the HICP towards the 4% mark and if Germany stays resilient a hike cannot be ruled out. For the record I, as well as most commentators, see a middle position and thus a holding operation.  

So, there you have it; you now know what to watch. Good luck!  

I am sorry to paraphrase, arguably, one of Hollywood's better conceptions; but having left the last Fed meeting and looking towards Thursday's corresponding action in London and Frankfurt I cannot help but feel that the tail just might be wagging the dog this time around. One thing is certain; ever since the credit turmoil began and the Fed started to aggressively slash the nominal interest rate to ward off disaster it was assumed ex ante that the ECB and perhaps other of the global central banks would follow as per function of the lack of de-coupling. Now, as investors seem to settle on the notion that the US is in fact in a recession it may be time to turn towards another of the bogey-man out there in the form of inflation. I am still a bit in limbo as regards to where I see things moving. I still see the ECB cutting rates at least once in 2008 on the back of an accelerated slowdown in the Eurozone but that move won't come on Thursday when Trichet and co. are likely to reiterate the chorus that inflation remains the variable to watch. Yet, this was also always going to be the main rub for central bankers in the sense that in a stagflationary environment their main and essentially only weapon of choice becomes increasingly blunt. Quite simply, in a world with free movement of capital, excess liquidity relative to the capacity to absorb it, and lingering structurally inbuilt interest rate differentials it is not at all certain that toggling nominal interest rates higher will have any meaningful effect at all. On the contrary, as we have seen across the global economic edifice many economies, emerging as well as developed, have been hard at work trying to hold off the pressure from capital inflows even in a situation of rather large external balances. Thailand would be a prime example here but more significantly in a global context such heavy weights as India, Brazil, and China on whose shoulders many hopes of recoupling lie have felt the pressure of the international hunt for yield. Obviously, this is not the case everywhere and across the Eastern European region as well as in Iceland external deficits are fast becoming a real issue.

So, what to do for those poor central bankers and more pertinently what does it mean that they don't seem to agree on what to put first in line of priorities assuming that they can see that there are both growth and inflation risks.It is in this light that I am suggesting that the dog is getting wagged rather than, as we have seen, the tail. Consequently, meetings at the BIS which began this Sunday had central bankers worryingly mainly about high and rising inflation. And what is more; they are even waking up to the fact that they stand largely helpless in doing anything about it at least in so far goes as a given central bank trying to quell the inflation bonfire in its respective domestic economy.

If we home in on the ECB who is deciding on interest rates later this week it even seems as if sentiment is solidifying behind the ECB's vigilance against inflation. Solidifying sentiment is of course unequivocally good and in a European context it even prompted Luxembourg Finance Minister Jean-Claude Juncker to exclaim that the ECB had become the inflation fighting machine we all wanted. So far Trichet and his minions have tried hard to live up to this adamant label. On several occasions both in the context of interest rate meetings and beyond have we heard hawkish statements from the ECB much to the chagrin of France's finance minister Christine Lagarde; I would imagine that they are also keeping more than a weary eye in Spain and Italy. As I have noted before the ECB is now faced with a growing divergences between the Eurozone economies. We don't have to look beyond the most recent data snippets to see this. As Edward details over at Global Economy Matters just about everyone save perhaps Germany is now beginning to feel the pinch (although I feel France may fair better than most imagine). Spain and Italy in particular seems to have entered what appear to become very severe corrections. To make matters more complicated the service PMI from Germany actually rose today while the aggregate Eurozone indicator stayed very close to th 50 mark of zero expansion (in fact, it rose a nudge). Thus, I still maintain my view that the ECB will soon have to go for growth rather than inflation. Two issues are however important here. Firstly, I want to reiterate a point I made on an earlier occasion that we will need to see a material slowdown in Germany before the ECB moves. Secondly, the newly found focus by a wide range of observers and investors on inflation relative to downside economic risks mean that the ECB may just have a stronger hand with respect to an adament view on inflation. 

Not everybody agrees though. Over at Morgan Stanley (may 2th GEF) Joachim Fels and Manoj Pradhan continue their ongoing global inflation watch and they seem to share my view (or I theirs if you will). Consequently, Fels et al believe that central banks will soon be inclined to go for growth rather than inflation.

We think breakeven inflation rates are distorted downwards by safe haven buying and collateral concerns, and true inflation expectations in the bond market may thus be higher.  However, even taking this factor into account, we think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years.  Thus, central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.

(...)

(...) we also think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years. Our bottom line: central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.

Behind this quote lies a critical narrative in which central banks falsely choose to neglect inflation risks in an effort to boost growth. As I have argued before I don't tend to see it this way or more specifically I think the current situation is a hell of a lot more complicated than blaming it on the central banks. Recently, I took a swing at precisely Fels and his colleagues for their analysis showing how in fact current interest rates in the Eurozone are accomodative. I think such claims are very hazardous and just as it may be a question of 'missing markets' it is also a question of an unprecedented process of global recoupling (unwinding of population and economic imbalances). Coupled with lingering wide global interest rate differentials this means that no one really knows what 'global capacity' is and much more importantly whether capital is being allocated in an 'efficient' manner. And speaking of which; recent news from the fx markets suggest that the EUR/USD is not as perky as it used to be. 1.60 consequently seem to have been the interim borderline. There can be many reasons for this (see Macro Man here) but more prominently is of course the question of whether those big wallet central banks are beginning lose their fondness for the Euro. In this way, a large part of this boils down to the whole Brad Setser/Macro Man detective work about just what China and the Petroexporters are doing since they are the big price movers and the speculators simply try to go where they go. As Macro Man notes It could seem as if someone with a big pocket sold off some Euros at 1.60 and now that we are hovering at 1.55 it will be interesting to see what happens next. Obviously a hawkish statement come Thursday could take it right back. Most still see the EUR/USD heading lower though but the key is whether we will see more rallies before this happens. Stephen Jen (permalink later) is musing about a EUR/USD at 1.40 at year's end. I fundamentally agree with him but there is also a strange lock-in effect here since who the hell knows what the equilibrium is? My guess is that as re-coupling moves on (and it will, just look at Brazil and their upgrade to IG) the EUR/USD will find a balanced level at some point but as long as strong interests are vested in terms of a fixed currency regime (or not) we could see a lot of volatility.

So, who exactly is wagging who here? 

It is obvious that growth divergence dilemma persists for the ECB. If anything, it has now grown worse with the recent abysmal data from Spain and Italy at the same time as Germany continues to run on the last legs of strong external demand. At the same time inflation continues to linger at levels far above the formal ECB target even though we actually saw signs of abating pressures recently. In this context, it may seem as if the market discourse has changed a bit in favor for the ECB's strong inflation stance as rampant food and energy prices are beginning to pop up on the agenda. I tend to agree with Fels et al. however when they say that the ECB ultimately will lower rates in 2008. I don't agree with the whole 'inflationist central banks' narrative however since I think the situation is a whole lot more complicated than as such. As for concrete calls it is pretty obvious that the ECB is going to stay pat this Thursday. Coupled with today's devastating news from the US housing sector (Fannie Mae's trip to the pillory is covered by Felix here) and the subsequent ripple effect in the debt markets a hawkish statement could take the EUR/USD back towards hitherto record levels of 1.60.   

I am finally back and not much different from the proverbial Phoenix so have the scribe at this space emerged from a rather tough patch of exam hardship. And this is none too late it seems as financial markets and economic data streams have served up an interesting set of new information. In this note, we are taking a trip to Japan and the recent slew of economic data for the month of March as well as other relevant information. Last time I did my monthly review of Japan the data had not budged much. This time is different. As per usual my analysis will progress by looking at Japan's economy from five angles which should subsequently yield a full picture of the current important yardsticks for assessing just where Japan might be heading. Consequently, I will have a look at price developments, domestic demand (also the labour market), domestic investment (and as a derivative here external demand) as well as the Yen. Immediately, there are two important questions which should be stated up front. One is whether I still see the BOJ cutting in Q2? I don't think so. As we shall see below derivatives trading implying future rate movements by the BOJ have, during the past month, moved from a dovish to hawkish and now back to a medium position where most investors and observers expect the BOJ to stay pat for the rest of 2008. The second question is whether Japan is heading for a recession. Upbeat data in the beginning of this month and the (most welcome) reluctance of the data to turn decidedly for the worse recently prompted Morgan Stanley's Takehiro Sato to somewhat retreat from his call that the global economy would see a dual-recession with the second unlucky economy being the US in this case. Since I have also been musing ominously about a potential recession in Japan am I about to retreat to? Not exactly, but I do concede that we are far, at this point, from an actual contraction in Japan. However, this also quickly turns into a alphabetic soup of just what kind of national accounts we are looking and how we 'deflate' the numbers. In Japan's case it e.g. depends on how we treat production vs. income. Basically, the current environment of stagflation means that traditional headline activity numbers need to be taken with a pinch of salt.

A lot of ground to cover then it seems. Let us commence.

If we begin with the development in prices the biggest news from the data was without a doubt how inflation has now returned to the shores of Japan. This was epitomized in the fact that even the price index stripped from food and energy managed to wring out a slight increase in prices at 0.1% y-o-y.


Yet, this is a far cry from the kind of 'escape' that was originally expected in the context of interest rate normalization in Japan and a positive spill-over effect as activity in the corporate sector as well as a tight labour market would lead to a recovery in Japan's hitherto slumbering domestic economy. Of course, the return of positive figures for Japanese inflation has prompted all kinds of knee-jerk reactions from commentators. Even the normally cool David Pilling from the FT was  carried away I think as he featured a story noting how Japan may now finally have 'shaken' off more than a decade of deflation. I remain very skeptical of this and I completely agree with Edward when he says that the argument of Japan escaping deflation would carry much more weight if we were standing on the brink of a recovery rather than in the middle of the worst global financial crisis for many years, a subsequent slowdown in global trade, and a resulting slowdown in Japan's economic edifice. The fact consequently remains that the domestic economy is still slumbering and in this light the passage of strong headline inflation to core prices has not have been an easy one. Most commentators and observers are now beginning to latch on to the narrative I, among others, have been pushing in the context of how Japanese inflation is driven by cost-push rather than demand-pull inflation. Reports are thus coming in about how rising raw materials now represent a paramount risk to the Japanese economy. Ken Worsley furthermore has a timely analysis on the recent data from the inflation front reiterating the point that inflation is coming from all the 'wrong' sources. Japanese consumers are thus still very pessimistic on future income expectations and obviously the current bout of inflation naturally weighs heavily here since it erodes real income. We should also understand that the passage of prices down through the value chain is not occurring without collateral damage. This is the whole point about cost-push inflation without the subsequent demand effect. A significant sign of this came with the reports that the amount of small-cap companies, who constitute 70% of the Japanese workforce, filing for bankruptcies rose 18% in the year ending March. To be slain by the sword or the axe seems to be the nasty dilemma for many companies as they are finding themselves in a double bind with no real ability to pass on the rising costs over to their customers. The inflation figures above thus suggest that inflation is now finding its way to consumers in other goods than energy and food. This could in principle be a good sign in the sense that if inflation expectations were to persistently move upward it could pave the way for that much allured interest rate normalisation in Japan. Moreover, recent news that wages were climbing on the back of changing regulation prompting companies to regularize part time workers is a very welcome structural change in terms of labour market dynamics. Yet, I think it is unlikely that this constitutes a lingering trend or at least I remain skeptical that what we have now is the beginning of a virtuous circle. On the contrary it seems as if the current price dynamics in Japan could now constitute more of a vicious circle.

As for the immediate future the current momentum seems likely to keep all three inflation indices in the positive for the next couple of months. However, core prices in Tokyo for April actually moved from a 0.1% increase to a flat reading of 0%. Given that this figure is a leading indicator for the price indices above (to some extent at least) I would not be surprised to see a return to deflation for April in core prices.

If we move over to the development in domestic demand the situation is obviously closely related to the analysis of prices above. The first months of 2008 saw a surprisingly strong showing from Japanese consumers but as I also noted there might be a distortionary bias in the numbers. Quite simply, with a situation resembling stagflation (driven by price increases in food and energy) consumers cannot but take on the increase in prices in the context of consumption of 'non-luxury' goods (i.e. for which demand elasticity is low.)

The first figure above shows, as per usual, the main data as reported by the media. As can be observed the decline in y-o-y consumption of -1.6% means that the initial strong showing at the end of 2007 and in the beginning of 2008 now has been somewhat paired . In fact, the average of the last four months slots in nicely with my general rule of thumb that we should not expect domestic consumption to grow by more than 1% in a Japanese context. For a fuller analysis of this headline consumption figure Ken Worsley provides the relevant information. Especially, the sharp decline in durable goods (i.e. the lacking demand effect again) seems to be a decisive factor in explaining the March figure. A look at the more long term tendencies for the recent two months indicates that we are moving on nicely around reversion to a declining mean over time. The reason as to why we have a mean with 'trend' here as we put it in econometric lingo is, I think, to be found in the context of Japan's demographic profile where an ever declining size of the working and income earning cohorts relative to the total population coupled with endogenous changes in life cycle behaviour (at least I think so) exert a structural pressure on domestic consumption. The future cyclical tendencies in domestic consumption are very difficult to gauge I think. One thing which casts a cloud over the next months' reading is the flurry over the gasoline tax which was not re-approved by the DPJ and may thus be reinstated which would increase gasoline prices and thus potentially push up consumption expenditures (or even divert resources consequently pushing down consumption). The main point is that monthly consumption figures tend to be clouded in a stagflationary environment. What would perhaps be more pertinent, and Ken Worsley's analyses are usually very much to the point, is to look at traditional strong demand components such as durable goods, semi-durables, furniture etc (household investment), auto sales, etc. in order to gauge what the real domestic demand effect is.

In this way, and as I have recently emphasised it would serve us more to look at tendencies in corporate capex (e.g. industrial production) and its connection with export growth if we want to assess the Japanese business cycle.


As we see in the figure above it could seems as if the curve is starting to dip. Obviously, the interpretation for cyclical analysis is not straightforward since we are talking about an index but I still think it is beginning to look as a turning point. As Edward notes here industrial production also nudged back on a monthly basis which suggests that economic activity is now clearly firming down. Not surprisingly the relative poor showing from industrial production comes in conjunction with a marked slowdown in the increase of exports. The semantics here are not insignificant since what we need to understand is that absent a recovery in domestic demand Japan needs a high increase in the growth rate in both exports and as a derivative corporate capex in order to keep the economy floating. If this rate of increase slows down significantly (even if it may not dissipate entirely) it also effectively means an erosion of Japan's only shield against a severe slump. In this light specifically, IMF's and WTO's recent warnings of a significant slowdown in global trade are especially worrying from Japan's point of view since she so desperately depends on being able to leverage external hotpots of economic growth in order to keep growth at a minimum sustainable level*. If the slowdown stabilises on the current level of increase which is a bit lower than the high levels seen in the summer/autumn 2007 I think Japan can weather the storm without experiencing a contraction. However, if the slowdown in capex and exports intensify I am unsure as to how much we can expect domestic demand to take up the slack and in any case growth will have to come down to much lower levels.

Finally, I should mention FX markets where the Yen as ever remains an important canary in the coal mine for gauging the overall risk sentiment in the market place. For a more thorough operationalization of this argument I invite you visit my post on the USD/JPY and its correlation with equity markets.

As we can see the Yen has weakened across the board since last time we looked at this chart and even though we are not nearing the soothing pre credit turmoil carry trading days (save in the context of the EUR/JPY cross maybe) it does seem as if risky behavior is returning to the market. Now, as Macro Man notes in the comment section here he finds that this past week has been rather puzzling. This may be so. However, I don't think that our good MM's compass is completely off and in our immediate context he asked this Thursday whether in fact risky assets and carry trade were once again, if perhaps temporary, the game to play.

The SPX broke 1400 just before and after the FOMC announcement, but there was little appetite to follow through; the close must have been disappointing to bulls. Similarly, USD/JPY flirted heavily with resistance around 105 earlier in the day but failed to breach it, thanks in part to reported Golden Week offers from exporters. Watching these two charts in tandem is probably not a bad idea; if both break and hold, it should suggest that the risk trade is "on, baby." However, if they both continue to jiggly about without showing much inclination to break through, it will send a powerful signal that all is not well in Denmark.....or make that risky financial assets.

I completely agree with MM when he notes that we should be watching the USD/JPY in conjunction with the SP500. As such, it could seem as if the bulls were exiting their pens to scour the planes once again. Surely, those with a knack for risky assets could use the recent employment data from the US to underpin their views. Moreover, the USD seems to be staging somewhat of a come back against the Euro as the economy of the latter fiat currency now decisively seems to be heading for choppy waters. On the Yen, it remains calibrated as a very fine thermometer measuring the degree of risk aversion in financial markets. I urge investors in this context to remember that the fundamentals of Japan's economy are next to useless in plotting the path of the Yen and if anything exerts the opposite effect of what the textbooks would claim. Personally, I am surprised to see that the EUR/JPY is back in the +160 territory and from a short term tactical point of view I think that a sell could be warranted here. The USD/JPY is now firmly back in the 100s and we consequently never really got to stay for long in the <100s for the MOF's patience to be tested. One part of the fundamentals which may actually be important here is how the Fed has now signalled, after cutting to 2%, that this will be the last cut due to upside risks for inflation. In summary on the Yen recent movements reflect a return of risk appetite to the market place ... whether this will linger is still quite unlikely I think so be careful out there.

In Conclusion

How should we connect the threads there then? A good place to start would be to revisit the two questions stated in the beginning. Is Japan heading for a recession and pending that question what I am expecting from the BOJ? As regards the first question it is pretty difficult to say I think but what is not difficult to see is that Japan is now set to slow down significantly. Recently, the BOJ noted (see a detailed analysis here) how the economic outlook had worsened in eight out of nine regions. This change in outlook was chiefly driven by the adverse effect of high headline inflation as well as a decline in corporate profit. On the latter the BOJ is expecting that capex will trend down not least seen in the light of a general slowdown in global trade. The charts above support this analysis. The MOF (ministry of finance) also recently reiterated the general point that economic momentum is fading on the back of declining business activity and investment. I don't think this is surprising. However, what comes next will be a big test of what the idea of a recovery actually means in a Japanese context. Many observers have voiced the expectation that as the external economic edifice slows domestic demand would be able to take over the baton providing a cushion for the low levels of business investment as well as consumption would provide a buffer. I remain very skeptical with respect to these claims. At the very least I expect that whatever change of baton we will see the receiving athlete in the form of the Japanese consumer will be moving at a considerably slower pace than we have seen in the past 18 months. In that vein I think that industrial production need to be watched closely from here on, especially in connection with the slowdown in global trade. One important brigth spot in this regard is the reports indicating that companies are beginning to take on more full time employees as per function of recent legislation. We even learned from the data that unemployment declined in March. This could in theory give a structural boost to wages and thus domestic consumption. However, the chains of economic fundamentals have not been broken. A large bout of economic research suggests that the increase in part time jobs in connection with an ageing workforce is driven by productivity effects as well as ageing workers' preference for supplying their labor exclusively in a part time context. As such, wages should not be expected to increase above and beyond labour productivity I think since this is not possible in the context of many Japanese firms exposed to external competition.

Finally, we have the future course of the BOJ. The new governor Masaaki Shirakawa started out on a hawkish note which even had investors expecting a raise in interest rates at some point during the past month. Such expectations have now been paired and at this point we are back to "normal" so to speak with the BOJ in a perpetual holding position. In my mind there is no doubt that the proverbial statement paving the way for a cut in the event of a rapid deterioration of economic fundamentals is made . However, the market discourse has also changed so as to make a weary eye on climbing inflation a higher priority relative to the initial response of massive damage control to counter the effects of the credit turmoil. In this light I want to hammer down that Japan's exposure to the credit turmoil does not come from the liquidity issue itself but rather from the potential adverse effects of a general slowdown in global activity and trade. For the immediate future I am moving in behind the market consensus pointing towards a holding BOJ for the next three months. This position is subject to a revisit should industrial production show further signs of an accelerated slowdown.

 
*Where of course "sustainable" in the long run here is virtually impossible but if the end point can be postponed it can buy us time to perhaps turn the ship around

The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro. Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this?

Especially, the last question is important to be aware off and essentially this is also at the heart of the inquiry Mary and IMF are making. In the context of Lithuania the dependence on foreign loans reveals itself on two accounts. Firstly, we have the composition of the external balance where we can see how the liabilities (i.e. the break up of the negative net investment position) is made up disproportionately much of bank loans compared to the more traditional components of portfolio flows and direct investments. Secondly, we have also seen how, as a result of the pegged Litas to the Euro, many of these loans are denominated in Euros. This is about balance sheet risks then in the context of translation risk which basically arise in connection with loans denominated in Euros and cash-flow/deposits where an overweight is in Litas. Obviously, this works well as long as the peg holds but in light of the discussion sketched above the risk is of course that the foreign banks suddenly retreat and/or that the Lithuanian currency is subjected to a pressure to depreciate as the external position becomes unsustainable. Quite clearly, any kind of market moves here would require the ECB to shield the peg since the currency board itself cannot be expected to keep the peg if the unwind really begins.

The main question I am asking here is what actually provided the build-up of foreign denominated loans in the first place and what the main driver is? Well, we are finally getting to the visual part of this note. As the first set of of graphs we have the formal illustration of what translation risk potentially means. Note that the graphs are updated with the latter part of 2007, a rather important point for the rest of the analysis (click on the pictures for better viewing).

Quite simply, translation risk can be measured by the extent to which these two figures are not alike. As we can see the loan composition does not match domestic deposit composition thus making the servicing of the debt vulnerable to potential currency movements. Moreover, these figures tend to underestimate the real translation risk since one thing is deposits another thing is the cash flow itself used to service the loans. In this light, one of the questions that has haunted me a bit lately when I looked at the charts is what exactly drives the fluctuations and general discrepancy between these charts.. One obvious explanation is that, per function of the strong foreign bank presence, the liquidity of the Euro credit market is a lot deeper than the corresponding market for Litas denominated loans. And as we shall see below this seems to correspond to reality since a deeper more liquid market quite simply translates into lower funding costs.

The three graphs above tell an important story about the market for credit in Lithuania and thus I imagine in the Baltics. As can be immediately observed borrowing in Euros is substantially cheaper than borrowing in Litas. Over the sample period in question the average interest rate spread in favor of Euro denominated loans has been 123 basis points (sd: 35 basis points) which should be more than enough to induce a considerable cross-price demand effect. Another interesting observation is that the trend in loan taking now seem to be parting ways with respect to currency denomination. In this way, the volume of outstanding loans denominated in LTL is beginning to decline where as it seems as if steam is still left in the Euro credit flows. Obviously, there may be both stock and flow effects where the latter would be how Litas loans were simply rolled over into Euro loans or, in the context of flows, simply that the amount of Litas loans were falling.

So, what on earth is all this good for?

Well, I think there are two main issues to note. First of all I should thoroughly try to formalize the connection between the interes rate spread and the composition of Litas vs. Euro denominated loans. As can be seen it seems as if the hump of the interest rate spread is indeed reproduced in the graph of the currency composition of the total loan portfolio. In order to investigate this I developed a small rudimentary regression model with the change in the differnce between Litas and Euro loans as a dependent variable and the change in the interest rate spread as an indepedent variable. This produces the following relationship (R-sq = 0.147, F: 6,20 (p; 0.0176).

If you really want the equation just drop me a note in the comments. The formal interpretation of the model is that a 1 basis point increase in the interest rate spread in favor of the Euro translates into a 32 basis point change in the difference between Euro and Litas denominated loans. E.g. if the interest rate spread widened .25% (25 basis points) in favor of the Euro (i.e. Euro loans got .25% cheaper relative to Litas loans) the change in the difference between Euro and Litas denominated loans would be 8% (800 basis points) in favor of Euro loans. Please note that this is not a very strong model in statistical terms but it does show that a relationship exists.

The second issue which is more pertinent in our present context is just what we can expect from interest rates going forward. Clearly, as Mary shows above (and as is widely detailed in the IMF report) foreign banks are now visibly beginning to wobble. As an appetizer of this we learned recently that a batch of Swedish banks recently suffered a dent in their Q1 profits on the back of the slowdown in the Baltics. We need to understand that this is just adding further to the perils of these banks since they are obviously already under attack on several other fronts not least in the context of securing financing for their operations in the interbank market. All this points to higher borrowing costs for those Euro denominated loans. Should that be a problem then? Well, not necessarily since as long as the credit market and currency peg is there the denomination of the loan is in fact all about where the low interest rate is. However, as I stressed above Lithuania need those foreign bank loans to finance their external position and if these suddenly dry up because the banks reduce activity and/or borrowing costs rise so much as to make them unattractive we are getting into trouble. In this context I don't see a major move out of Euro denominated loans at this point but that does not mean that the costs of servicing these won't increase. Basically, the banks can do two things. Follow the economy down raising rates and curbing lending or they can write off their losses. In reality it seems as if a process of 'a bit of both' has already begun and now it remains to be seen whether the squeeze becomes so tight elsewhere that some of these banks opt to significantly reduce activity. In this light, Lithuania in itself can hardly bring down any but perhaps a local bank but as Mary warns the contagion risk is not insignificant. Moreover, the issue of the inflows themselves are important since Lithuania, and the rest of the Eastern European gang, has an external deficit to cover. If suddenly, the inflows in the form of foreign bank loans retreat (and they will to some extent) there will be a short fall and since the Litas cannot correct we could see a rather rapid transition from rapid inflation into deflation as this would be the only way to correct the external position.

Ultimately, I am not trying to pull another doom and gloom rabbit out of the hat here. The risks I have pointed to here represent nothing new in the general discourse. What we do need to understand though is that; if the inter-relationship between the foreign banks and Eastern European and Baltic consumers/corporations hitherto was in a honeymoon stage with plenty of mutual benefits for both it is now set to become a dance macabre (or a tango if you will) and we know that this takes two to tread.

As you can see in the post just above this one exams are forcing me to quit the blogosphere for a couple of days. As a last spurt I wanted to comment on a couple of things. First of all, the I note how the ECB is increasingly coming into the spotlight. A couple of days ago we thus got the governing council's über hawk Axel Weber who ventured the idea that perhaps interest rates in the Eurozone were too low putting the final nail in the coffin of everyone who thought that the ECB would cut in Q2. The econsphere's in house Austrian economics analyst Stefan Karlsson moved in behind Weber noting that of course the Eurozone interest rates were not high enough. An inflation running at 3.6% as well as growth in the aggregate monetary base (the M3) seem to merit these conclusions but the looking at the data the situation is a bit more complicated as I tried to argue in a large recent note. Of course, at this point we also really ought to put the hawks' argument to the test. How far and long should the ECB raise rates in order to bring down inflation to the target (2%) not to speak of bringing the M3 growth within range of its 3-4% growth target? Given that there must be a short term nominal rate target for achieving these aims and a path dotted out through which to reach this rate level what would the ECB do to Spain, Italy, Portugal, Greece etc not to mention Germany itself who is bound to slow too.

So, that was a small intermezzo on the ECB in relation to my recent note on the topic. In reality, what I wanted to spend a little more time on relates to something I mentioned on international migration in my previous post on global demographics (which is already stirring up a hot pot of comments over at Demographics.Matter) where I reviewed a recent paper by David S. Reher. In this post I latched on to a point made by Mr. Reher in the context of international migration and how some countries might see adverse effects from exporting its surplus labour to other countries. The argument was specifically centered on transition economies but, as you can see below, the argument can also be expanded. The main issue becomes one of rearranging those proverbial deck chairs on the Titanic (i.e. to get the best spot relative to watching the inevitable demise of the ship) as many countries across the globe seek to mitigate a labour dearth by importing foreign labour. The allure of such policies should not be neglected. Relative to actually doing something about the underlying issue (i.e. nudging fertility back up) receiving foreign labour becomes an instant, if only temporaneous, fix for labour shortages and even in some cases the source of unprecedented economic booms (Spain would be an excellent example here). In this present context it would serve us well to take a trip to Germany and by derivate to an eloquent piece in the IHT (aggregated from Reuters) by Erik Kirshbaum. As Kirshbaum neat points out we all know that Germany is hard at work trying to export its way out of economic trouble but also, as it were, into trouble. In this way, it is one thing shipping off semi-conductors and cars but quite another to ship out human capital the latter becoming an increasingly scarcer resource in Germany.

Still plagued by high unemployment owing to the turmoil of reunification in 1990 and rigid labor laws, Germany has been helping its skilled and less-skilled jobless workers match up with foreign employers searching for manpower. The country has also been offering financial support to cover moving and transportation costs for unemployed Germans searching for jobs across the European Union, and even as far away as Australia and Canada. In one typical example, a newspaper in Fuerteventura, one of the Canary Islands of Spain, was recently filled with advertisements placed by Germans hunting for jobs.

"German seeks job in hotels or tourism," read one. "All relocation and travel costs paid for by German Labor Office."

Germany had an unemployment rate of 8 percent in February, about one percentage point higher than the euro zone average: 3.6 million people in the country are without jobs and more than 155,000 Germans emigrate each year. Many thousands have been helped by the Labor Office's International Placement Service in Bonn, which offers to some "Mobilitãtshilfe" (mobility assistance) or a "Mobilitãtsprãmie" (mobility bonus). The financing, known as the "Mobi," helps cover moving and travel costs for jobless Germans and their families. It is discretionary and aimed at those with job prospects abroad, although it is also available for relocations inside Germany.

"The mobility assistance benefits can be used for moves to anywhere in the world," said Sabine Seidler, spokeswoman for the International Placement Service in Bonn. "They're granted on a case-by-case basis and there's no upper limit on the sum involved. Applicants usually must have a contract and meet certain criteria. The main purpose is to help those who've lost their jobs find work as quickly as possible."

As we can see here the policy of helping people to find work abroad was and, perhaps much worryingly, is being encouraged. Re-locations inside Germany are of course one thing but actually helping people to leave Germany seems to be extraordinarily ill-advised at this point. Obviously, we can all see how it helps perk up unemployment statistics but as a long term policy it is anything but sound. Some however, are beginning to sound the alarm ...

In Germany, the assistance is controversial. Economists and industry leaders say paying people to leave a country with a shrinking population and one of the lowest birth rates in the world is a recipe for disaster. Shortages of skilled labor are now acute in industries like engineering and car production, but they also loom in sectors like retailing, health care and finance. Meanwhile, "depopulation" has become an explosive issue in some areas, especially in the formerly Communist east.

"It's obviously better if they find work in Germany and pay tax, as well as contribute to the state's social welfare system," said Werner Eichhorst, deputy director of labor policy at the Institute for the Study of Labor in Bonn.

"In the short term, emigration takes people off jobless rolls, but in the long term we're losing workers with skills," he said. "It's usually the best and most flexible who leave. They're also often at ages where they have children. They're lost to Germany and obviously their children won't contribute later either."

The article also quotes Deutsche Bank's chief economist Norbert Walter for saying that even though he formally supports the mobility aid Germany should try kick it into reverse. Specifically Walter mentions how Germany will need to attract a significant amount of immigration in the coming years to compensate for the decline in the labour force. Right on cue Mr. Walter. Unfortunately, with Germany's size and the region's demographic trends (e.g. in Eastern Europe) this is going to be anything but the trifle Mr. Walter seems to think. Essentially, I don't think I can express myself much clearer than this. Germany desperately needs to instigate a sound policy on migration. The current one which in some ways encourages skilled labour to leave is way past its time and peak.

Regular readers of this blog will know that I ascribe a high level of significance to demographics as a real macroeconomic variable. In fact, I often tend to investigate, for analytical purposes, the strict and exclusive effect of changing demographics on various macroeconomic issues and contexts. I do this in the spirit of falsification and because I subsequently believe that all good theories constantly must be put to the test if they are to remain strong, agile, and adaptive to new findings. Yet, what are the global demographic trends then? This question cannot be answered in even the most ambitious blog post. However, we could do much worse than to visit a recent paper by David S. Reher entitled Towards Long-Term Population Decline: A Discussion of Relevant Issues. The paper is as per usual walled for non-subscribers of a university server but you can get a long most adequate survey of the paper here at Edward's Demography Resources.

Let us begin with the abstract which contains two crucial points that are very important to take away.

This paper contains thoughts on the process of imminent population decline under way in much of the developed world and quite possibly in other world regions as well. We are witnessing the beginnings of a vast trend change which promises to bring to a close a period of population growth that has lasted for several centuries. It can be shown that this great change is a byproduct of the demographic transition that unleashed a number of the forces leading to where we are today. The extent to which much of the developing world will follow the reproductive trends of the developed world, with their social and economic implications, is discussed. The decades ahead for much of the world will lead us into mostly uncharted territory that bears few similarities with past periods of population decline. The purpose of this paper is to stimulate reflection and debate on a subject that looms as perhaps the key social issue of the twenty-first century.

As many of you may know from rudimentary knowledge of demographic processes the original idea of the demographic transition always encompassed the idea that fertility would stabilize at replacement levels once the final stages had been dispensed with. This is then to say that the original idea of the DT envisioned a notable degree of balance (homeostasis) in the level of population with the obvious exception that an ever marginal decline in mortality coupled with a rise in longevity would steadily translate into ageing of the world's population. We know now that this idea of a balanced steady state (and no, this choice of word is NOT coincidental) in fertility must be seriously doubted and for all intent and purposes discarded as a valid theoretical explanation. Consequently, it is only very few developed countries today that can boast a fertility rate at replacement levels and indeed if we pull out the ruler none of the developed economies save perhaps the US qualifies for the strict definition of replacement fertility. This must then be the first important thing to take away at this point. The demographic transition or more specifically the evolution of fertility and rising life expectancy is not over and at this point there does not appear to be a theoretical governing mechanism to provide a balance. On the contrary and most worryingly we are now observing that the rapid decline in fertility which has occurred across a wide batch of developed economies is now being repeated, and more importantly fast forwarded, in the context of many emerging and transition economies. Notable examples here would be Eastern Europe, large parts of Asia, as well as Northern Africa. Conclusively this leaves us with two intertwined points which are absolutely crucial to be aware of. Firstly, and as I have argued before the demographic transition is not over and following from this is, as mr. Reher puts, the fact that we are moving into uncharted territory.

In general, I would say that Reher's small article is a good starting place if you want to understand some of the issues at work and also if you want to understand what the historical background of the demographic transition is. Reher frames his discussion around the issue of population decline and how world is now moving into a new regime of steady to declining population dynamics. Obviously and since mortality rates have declined much faster than fertility rates it will take some time before the global population actually start falling in numbers even if of course notable asymmetries are present. For example Russia's population is already declining and so is Japan's and unless aggregate European fertility rates rise to an almost unimaginable number the population will begin to decline slowly here too in a few years (also it has to be said with important asymmetries). Even though this perspective is important I am not a big fan of narrating the demographic changes in the context of population decline. There are two main reasons for this. First of all I think that population decline on a global scale need not be a detrimental development for the human race. In fact, a considerable amount of evidence supports this. Secondly, because I am convinced that the main economic effects from demographic changes need not be found in the context of declining populations in absolute numbers but rather in the form of the rapid and relentless process of ageing which is sweeping the planet in these years. Reher of course also notes this and mentions several times the potential impact of ageing. However, I like to take it even further. Another way to look at the demographic transition is consequently to look at it as a transition in age structure of a society. I am thus very much in tune with the original work on this conceptualization by the Swedish demographer Bo Malmberg. In this way and from a macroeconomic point of view the focus on ageing and changing age composition of a society opens up an important unattended flank in the realms of macroeconomic theories of growth and capital flows. In this context I feel that the following issues are very important to keep in mind ...

• The implied notion of an economic steady state runs into severe calibration issues in the context of the ongoing demographic transition. Growth theorists, of course, were always from the beginning aware of the potential effects of a skewed relationship between old and young people in a society. A whole battery of research consequently exists under the common notion of OLG (overlapping generations framework) which deploys standard life cycle assumptions to derive steady states in a modeling context of a rudimentary age structure of society. However, the theory runs into distinct problems when trying to formulate a steady state framework for countries that do not appear to exhibit a steady level of output growth over the long run. In this way, the steady state becomes a proverbial moving target. In addition there is evidence to suggest that the demographic transition is not a deterministic process but rather path dependent and thus endogenous to the growth process itself. Given the fact that we don't how this process ends it makes the potential modeling endeavor extremely difficult.

• Economies today are not closed but highly interdependent. If we couple this with the fact that the process of ageing occurs in radically different tempi across the batch of global economies I believe a number of important externalities can be identified in the context of the global economy. What does it for example mean that Japan is running a near 0% interest rate policy because it has found it impossible, after more than a decade, to effectively escape deflation? What does it mean for global capital flows that some economies are now, not only prone as the original theory predicts, but rather dependent on external demand to grow? And what happens as all the global economies steadily age thus all becoming ever reliant on external demand to grow?*

• Growth is above and beyond driven by the availability and quality of human capital; both on a macroeconomic and microeconomic level. Institutional set-up matters in the sense that they can make or break an economic edifice depending on their efficiency but without human capital the economic engine does not work. Institutions can be a powerful catalyst for the quality of human capital but on the other hand modern institutional arrangements also seem to be at the very heart of the dramatic decline in human capital formation (fertility) we have observed and indeed are observing. Moreover, there is evidence to suggest that a negative feedback mechanism is at work with respect to the quantity and quality of human capital. And as Edward likes to frame it, a society has a maximum capacity for growth when its age structure is at a specific golden level (i.e. when the most productive cohorts (say 25-45) are at their maximum size relative to the whole population). Yet, as the demographic transition ripples through this median moves steadily upwards and in this context the extra productivity extracted does not carry the same weight as it did before. In fact, and going back to the idea of a steady state it seems a very sound theoretical assumption to state that in order to observe a steady state of economic growth we need to have a balance by which the size of the most productive cohorts is fairly stable (the US would seem to be almost the only empirical precedent here).

These are but some of the questions which arise in the context of the global demographic changes and their impact on the economic environment.

If we return to Reher's piece I think that a couple of noteworthy rather random points can be extracted.

As I have relentlessly been arguing in the context of the topic at hand one of the most preoccupying concerns is that the observed and lingering trend in the developed world now seems to be repeating itself in the context of the world's emerging economies. In fact, as we have seen a wide array of transition countries are now finding themselves with severely damaged population dynamics. Reher is very specific on this topic which he uses essentially to argue that the world is now, for better or worse, entering a completely new and unknown demographic regime. Also he latches on to the idea that the demographic transition is indeed a path dependant process and not one which occurs automatically in the context of a pre-scheduled process of catch-up growth from the point of view of transition economies ...

Throughout the developing world, aging and its attendant economic and social challenges will become an acute social issue relatively soon after it becomes a central concern for societies in the developed world (Demeny & McNicoll, 2006b, 257–259). The intensity of change will leave these nations with but a brief window of the opportunity for modernization within which to take full advantage of the ‘‘demographic dividend’’ derived from their own transitions (Bloom et al., 2003).

What drove (and drives) this rapid demographic transition in the first place? This is perhaps where Reher is most elaborate. He consequently engages in a large and detailed discussion of the social change that occurred along side the demographic transition. Specifically, Reher devotes a large section to the changing role of women in our society and what effect this has had on childrearing. As far as I can see especially an elaborate account of the quantum effect of fertility emerges (curiously without a reference to the original work by Becker and Barro). Reher especially devotes attention to the process of family planning and completed family size. This is then an entrance point to the tempo effect (postponement of births) of fertility decline. As such, at any given point in time couples (or women) have a desired family size but the steady process of birth postponement may exert a notable influence on the final fertility level (i.e. cohort fertility). Moreover, Reher also refers to studies by the Austrian demographer Wolfgang Lutz who has devoted a lot research to the idea of a convergence towards a common very low level of fertility in Europe. An even more interesting side issue here is to actually develop a theory to explain these developments in desired family size potential convergence towards a one-child ideal. A considerable amount of debate has been made in the context of European sociological studies and specifically in relation to studies which have shown how many women in Europe's low fertility regions do not want to have children at all. A couple of months back Edward had a very elaborate piece on Demography Matters on this topic. Ultimately of course the idea that all this in the main can be pinned on the emancipation of women in terms of labour force participation and the social changes which accompanied it remains a rather dubious theory. Edward shows us as much in a recent very detailed analysis of Italy's demographics.

Finally, Reher manages to hit the proverbial nail on the head with his comments on international migration and the potential for ageing societies to mitigate their demographic travails through importing labour.

Labor shortages will be one aspect of the issue of aging. In some countries, this shortage of working age population is easy to predict because numbers of births have already been declining for several years. We believe that it is only a matter of time (perhaps 2–3 decades) before they begin to affect many or most societies in the developing world. The availability of surplus labor (potential migrants) to compensate the dearth of labor in the developed world may eventually be called into question, as the sending countries begin to suffer labor strictures of their own.

(...)

International migration itself, the focus of much current attention and concern, is unlikely to represent more than a temporary and rather inadequate solution for skewed age structures and population decline for two reasons. (1) Fertility among migrants, while initially higher than among the native populations, very quickly tends to decline to levels holding in the host society. (2) More important, perhaps, is the fact that many sending regions will be experiencing labor shortages of their own within two or three decades. It is unquestionable that these countries currently have abundant supplies of surplus labor that can be funneled fairly directly to receiving countries, normally developed ones, suffering from labor shortages. This situation, however, cannot be sustained indefinitely because of the dramatic fertility decline
taking place among those sending countries.

The only problem here with Reher's account is his time frame. 2-3 decades is way too optimistic. These issues are here today and very soon, if they are not already, they will come on the political agenda most prominently in Eastern Europe where for example the EU is still spinning the inter-relationship where CEE and Baltic migrants travel to the West as a positive one. The fact is that it is not and if the EU does not wake up to this they may end up with a lot dissatisfied new member countries.

In Conclusion

Reher's piece is well worth more than a scant glance. What I particular like was already emphasised in the beginning of this review. The demographic transition is not over but remains an ongoing process and this means that the global economy or society is moving into uncharted waters. At this point we already know a lot about the effects of demographic change but since we don't know the extent and/or the end of the changes themselves we are faced with a rather peculiar scientific problem. Personally, I tend to, unlike Reher, focus mainly on the dramatic force of ageing which is sweeping across the global economies. Especially, I like in this context how Reher emphasises the fact that the demographic transition seems to be moving much more rapidly in emerging and transition economies. This is a very important empirical fact to take away. In this respect I also think that Reher manages to pinpoint very accurately the issues which pertain to global trends of migration from the point of view of the sending countries rather than the traditional spin that this is a win-win situation for all parties involved.

A lot of literature is out there on this topic of the general trend in global demographics but I do think that Reher's piece is one of the better specimen.

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 is 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.