Euro bankers say they’re keeping an eye on inflation — while America’s coming loose
On January 21, Federal Reserve chairman Ben Bernanke abruptly cancelled plans to travel to New York so he could stay in Washington to engineer the largest one-day reduction of interest rates in recent times. His counterpart at the European Central Bank, Jean-Claude Trichet, did not change his travel plans — or his policy. Taking care to give the European bankers a heads-up before a public announcement, Bernanke sharply cut the Fed’s benchmark lending rate 0.75 percentage points early the next morning, partly in response to plunging global share prices. The next day, with Europe also weathering market turmoil, Trichet coolly told the European Parliament in Brussels, Belgium, that the bank, based in Frankfurt, would keep rates steady in spite of the Fed’s move. “There is no contradiction,” he said later that week, “between price stability and financial stability.” The contrasting ways Bernanke and Trichet responded to the crisis in the markets reflect something more than differing economic and financial conditions in the US and Europe. At a more fundamental level, they reflect surprisingly different views of how each economy responds to the underlying forces affecting growth and inflation. The Fed’s mandate, balanced between fighting inflation and encouraging full employment, leads to a simple investor calculus: if growth sags, the Fed is virtually certain to cut interest rates. Usefully for the Fed, which seems likely to cut its benchmark short-term rate below the current 3%, inflation in the US tends to fall as demand slackens during a slowdown. And even though inflation has been rising to worrying levels lately, the Fed appears to be counting on that rule to apply again. The European bank, by contrast, is sceptical of the notion that inflation automatically falls when growth cools and it has a mandate, inherited from the German central bank, to keep prices stable above all else. So the view from the European bank’s sleek, silvery headquarters is very different from the Fed’s perspective in Washington, whatever market participants may think about the inevitability of lower European interest rates. Trichet is likely to drive home this point after the central bankers emerge from their monthly meeting on Thursday, when they are expected to leave rates unchanged at 4%. Many investors remain convinced that the European bank has little choice but to follow the Fed’s lead, if only to ensure that recessionary conditions do not leach into Europe. Investors have bet that the bank will follow and lower its benchmark rate, certainly by June and possibly earlier. The rise of the euro, which breached the 1.50 threshold last week and settled in New York on Wednesday at 1.5262, also increases pressure on the bankers from European politicians to at least hint at lower borrowing costs. Falling interest rates in the US have exerted a powerful force on currency values by dampening the appeal of dollar-denominated assets. “In the present circumstances, we are concerned about excessive exchange-rate moves,” Luxembourg Prime Minister Jean-Claude Juncker, who is presiding over the group of 15 eurozone finance ministers, said on Monday. But what sets off alarm among politicians in Europe is far less likely to raise hackles at the central bank. That is because the euro’s rise also helps curb inflation by lowering the cost of imported goods. And if the euro’s appreciation is smooth, it supports the bankers’ decision so far to stand pat. At its core, market expectations of a rate cut in spite of the European bank’s warnings that inflation remains its primary concern stem from the bank’s failure — nearly 10 years after it was created as the steward of the euro, now the common currency of 15 nations — to emerge from the Fed’s shadow. “Markets tend to put a very high correlation on Fed interest rates and European interest rates,” said Klaus Baader, chief Europe economist at Merrill Lynch and one of a minority of European bank watchers who maintain that the bank will keep rates steady all year. “That was the case when European monetary policy was driven by the Bundesbank, and it is true now.” While the central bank could end up lowering rates if conditions change significantly, it is struggling over how to change the perception that a rate cut is inevitable. Consider what happened when its council gathered behind closed doors in Frankfurt on January 10 after a usual working dinner the night before. At that point, its members — the six top bank officials and 15 central bankers of member countries — found themselves embroiled in a lively and previously undisclosed debate linked to market expectations. They had already decided to leave rates steady. As a result of rising energy and food prices, inflation was running at an annual pace of about 3%, above the bank’s goal of keeping European inflation under 2%. The council members were wrangling over a proposed statement that included a threat to act “pre-emptively” if labour unions tried to embed higher energy and food prices into new contracts, risking a new wage-price spiral. Trichet has long held that central banks do their best work when their threats to raise interest rates deter inflationary actions in the first place, avoiding the need for excessive swings in the benchmark rate. In a speech at the annual meeting of central bankers in Jackson Hole, Wyoming, in the US in August 2005, Trichet called this concept “credible alertness”. But there was another reason for including it. The central bankers had agreed that they had to offer a slightly more downbeat view of the euro area’s growth prospects in the opening paragraph of their monthly statement. Financial market turmoil showed no sign of ending, and with each day, the risk rose that banks would constrict the flow of credit to the real economy, endangering business investment and consumer spending. European Central Bank officials knew that a message about slower growth would inevitably fuel speculation that it was opening the door to lower rates. So, against the wishes of some council members, the threat was added to help counterbalance the message on growth. The episode has been widely viewed as a communications failure, and the word “pre- emptively” disappeared from the next month’s statement. “In my view, this was a pretty clumsy move,” said Charles Wyplosz, a professor of international economics at the Graduate Institute of International Studies in Geneva. “They had to drop it unceremoniously when it didn’t work out.” But in spite of the statement’s awkwardness, it reflected the central bank’s poorly understood view that strong employment protection coupled with muscular labour unions and generous social benefits act as a brake on falling demand. And if higher inflation is being imported through commodity prices, any automatic link between lower growth and lower inflation cannot be taken for granted. — © The Times, London.
