Fundamentals

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Ben Bernanke warns the market about inflation and a weak dollar but forgoes a rate hike. Jean Claude Trichet raises rates but drops verbal intervention. Six months is an age in the currency markets and the euro is trading square in the middle of the 1.5400/1.5900 range that has dominated since early March. Neither central bank has been able to affect the euro/dollar rate for almost half a year and for one very good reason: the trading rate of each currency against the other is a distant third in the responsibilities and concerns of the European Central Bank and the American Federal Reserve.

Two parallel quotations from a month apart: Ben Bernanke on June 3rd, "For now policy seems well positioned to promote moderate growth and price stability over time"; Jean Claude Trichet on July 3rd, "The monetary policy stance following todays decision will contribute to achieving our objective".

Both central bankers are trapped between their primary responsibility, for the ECB inflation, for the Fed economic growth and jobs, and their secondary mandates, GDP growth for the ECB and inflation for the Fed. Each has been true to their primary responsibility while hoping for the best with the second. And both central bankers have kept their word for transparency by keeping the markets apprised of their changing policies and largely free from rate shocks. Neither bank provided any drama with their most recent policy pronouncements.

Only developments in the American and Eurozone economies can release Jean Claude Trichet and Ben Bernanke from their respective traps. American statistics have been slowly turning south for six months. Non Farm Payrolls registered its sixth consecutive negative result and US payrolls have now lost almost 400,000 jobs since January. The Fed has already prescribed and administered its economic medicine, 325 basis points of rate reductions in the past ten months. There is a limited amount that the Fed can do to provide more stimuli.

Eurozone inflation has more than doubled in a year. The ECB raised rates 0.25% but such a hike cannot squeeze inflation out of the European Monetary Union (EMU) economy. At best it is a warning to unions negotiating for wage increases. The ECB cannot prevent inflation with rate hikes; it can only retard the development of the feared wage - price spiral. It is essentially anti-inflation rhetoric by other means. Further rate hikes could quite easily push the EMU economy into recession. But even a recession might not prevent inflation in Europe.

It is not an overheated economic cycle at the end of its run in either the United States or the EMU that is driving inflation. The US has been slowing for three quarters; inflation is rising. The Eurozone countries have had moderate growth in the same period, growth that is nowhere near the level that would double the inflation rate in a little over one year.

The current inflation in the US and the EMU stems from a level of worldwide demand for raw materials and commodities fostered by basic infrastructure expansion on a scale not seen since the reconstruction of Europe after the Second World War. Higher rates in the EMU and the US will have limited effect on domestic inflation since its origin is in a worldwide phenomenon. Demand destruction worldwide is the real key to inflation in the US and the EMU. If the US and EMU enters recession, China and India , for example, will follow to lower growth, but probably not recession - their internally based expansion is strong enough to prevent a recession - and that will finally diminish inflation in the developed world.

Resource demand will slacken with a developed world recession but commodities will not return to price levels of a decade ago. Oil will not return to $50 a barrel until substantial new sources are developed, likewise for industrial commodities and food. The world must make a new leap in production for prices to fall. The consumer lifestyle of the developed world, resource intensive and profligate, is spreading around the globe. That lifestyle, more than the rate policy of central banks, is determining growth, recession and inflation. There is no alternative to higher demand and higher prices except greater supply.

Neither the ECB nor the Fed is in full control of their economies. The world has changed. More than ever before domestic economies are propelled by the global market. Even the strongest central bank is now but one factor in the global economy. The shrunken domain of the worlds central bankers is clearly demonstrated by the current inflation and growth crisis in the developed world.

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