- The ECB rate bias fizzle

- European rhetoric and reality

- American gloom

Did Jean Claude Trichet, the European Central Bank (ECB) President really put the central bank on a neutral bias last week? After the bank held rates at 4.00%, citing downside risks to growth and Mr. Trichet noted that 4.00% allows price stability it certainly seemed that the European bankers were preparing the market for a change in policy. From a neutral bias to an easing bias, from stable rates to falling rates and a depreciating euro, is a short step mediated only by a central bank’s need for deliberate and studied movements in policy. The euro fell two figures against the dollar after the ECB announcement and traders were set to take it lower. But without follow through even a central bank pronouncement dies a quick death. European GDP did not show a faltering economy in the fourth quarter. Mr. Trichet and Axel Weber, ECB board member, President of the German Bundesbank and staunch inflation hawk quickly returned to their anti-inflation rhetoric and the euro slowly climbed back to the middle of range it has held against the dollar since late November.

Had the US economy delivered stronger figures this week or the EMU weaker ones, the ECB rhetoric would have mattered little and the euro would likely have continued to fall. A rate neutral ECB is a new factor in currency market assumptions and one that normally leads, in time, to lower interest rates. Declining ECB rates are clearly not priced into the current euro dollar levels, hence the plummet last Thursday. But even without corroborating European and American statistics the euro would probably have continued to fall against the dollar, if Mr. Trichet and company had kept silent. But they did not. Why would the ECB adopt a neutral rate outlook one week and then publicly contradict it the next?

One thing central bankers do not want, if they can prevent it, is for rapid changes in currency rates to become a factor in their own calculations or to add a complicating factor to an already difficult economic environment. Put plainly they do not want the currency markets to anticipate too much or too quickly. The change in ECB bias from tightening to neutral was deliberate-- the next ECB move will be a rate cut. But the subsequent talking up of inflation was just as deliberate.

If the euro rapidly deflates on speculation that the ECB will soon cut, as would be natural after an unchecked change in bias, then the pressure for the bank to act as the market anticipates becomes that much greater. The European bankers are anticipating lower economic growth otherwise why put the bank on a neutral base after months of strident anti-inflation rhetoric. EMU economic activity is supported by exports and exports are curtailed by a strong euro. Market speculation on an impending ECB rate reduction cycle world, if left uncountered, quickly drive the euro lower. Similar speculation on a US economic slowdown after the credit crisis erupted last August drove the euro 12% higher in only three months. And there is nothing to prevent the reverse happening now. However, though the ECB governors may have concluded that they will have to cut rates at some point in the future, they do not want their timetable affected by currency traders, or at least they want to minimize such effects.

If the euro deflates rapidly between now and the March ECB meeting and the governors determine then that the time is not yet ripe for a cut and they do not, then the euro could easily reverse and flood higher. The turmoil that such violent currency moves create in the world financial system confounds the bankers’ attempts to restore calm and insure financial stability. The last thing the world’s central bankers want in the current tense state of the world’s financial system is complication. Calm and deliberate adjustment in currency rates is the bankers’ goal. Unfortunately for them the world’s currency markets are not calm and deliberate places. Thus we have seen the back and forth of ECB rhetoric and the screen of words hiding a true change in intention.

But there is another complicating factor in the central bankers view, uncertainty. The world economy has evolved rapidly in the past ten years. Asia has added huge amounts of wealth and consumer spending to the world’s economy. But whether Chinese and Indian consumers can prevent a US recession is unknown. Add to this the waves of deleveraging losses washing through the banking and financial system and the unresolved crisis of confidence in the credit markets and you have a situation primed for speculative upset.

The G7 meeting last weekend in Tokyo produced small changes in the communiqué and none in economic policy or forex outlook. The general forex statement was unaltered; it has been basically unchanged since 2004. Exchange rates should reflect economic fundamentals, and excess volatility and disorderly economic movements are undesirable, are the venerable mantras. The wording of this section was identical to that of the prior communiqué. The Chinese were chided ever so slightly to keep yuan appreciation on track. The text of the communiqué from the previous meeting in Washington said we encourage the Chinese to appreciate the yuan. This time the text read we stress its [the Chinese] need to allow accelerated appreciation of the yuan. It was less than a minor change, in fact it was an acknowledgment of the doubling of the yuan rate of appreciation from 2006 to 2007 and the influence Chinese reserves and debt holdings have with the finance ministers and government officials of western industrialized nations.

Central Banks

Federal Reserve

Federal Reserve Chairman Ben Bernanke’s testimony before the Senate Committee on Banking, Housing and Urban Affairs broke no new ground. He repeated the Fed stance that the economy is beset by credit, housing and employment risks to economic growth but that the governors do not expect a recession. He predicted that the stimulus effect of rate reductions will work through the economy generating moderate growth in the third and fourth quarters. With rates at 3.00 %, the result of a 225 basis point reduction in a little more than four months, the Fed is likely to be approaching, at least in planning, the end point for reductions. Patience is a possible theme for future Ben Bernanke pronouncements though it was not much in evidence this week. Every indication is that more cuts are coming at the March 20th – 21st FOMC meeting.

European Central Bank

Jean Claude Trichet, president and monetarist did not sound like a banker preparing to cut rates when he said, paraphrasing American economist Milton Friedman, that inflation is ultimately a monetary phenomenon. European Monetary Union (EMU) money supply growth, 11.5% in December, is almost 50% higher than the stated ECB target of 8.0%. It is not a statistic Mr. Trichet would draw attention to if a rate cut was in immediate contemplation. Mr. Trichet also tended the economic side of the rate policy argument by noting that economic conditions are not the same in the US and the EMU. And, he said, the ECB is doing what is necessary in its own circumstances by insuring price stability.

Axel Weber, Bundesbank Governor and ECB board member returned to his normal position on the inflation watch warning that inflation and price stability at the only sights on the ECB horizon. Against the backdrop of these [economic] prospects the current interest rate expectations in financial markets do not—at least not for a stability driven central banker—reflect an appropriate evaluation of the inflation risks’. It was an unusual personalization of his position, but the message could not be clearer, do not factor rate decreases into your positions.

Bank of England

The Bank of England quarterly Inflation Report was a warning that the pace of rate reductions postulated by the market may be overdone. The report predicted that inflation will be just over 2.2% in two years under the current market expectation that rates will fall from where they are now, 5.25%, to 4.8% in the second quarter and to 4.5% by year end and to 4.4% in 2009 before rising again. Inflation would peak at 3.00% in the second quarter of this year under this scenario. At a constant 5.25% rate inflation would be well below 2.0% in two years. The bank’s GDP forecast was reduced below 2.0% for 2008 and with expressed concern for downside growth risks. The best reading of the report is for two more 0.25% cuts, with the timing front loaded in 2008.

As with its American counterpart, the British central bank is more worried about growth than inflation and will probably cut rates again before the May inflation report. But the governors do not want market expectation to get ahead of themselves. In the central projection higher energy, food and import prices push inflation up sharply in the near term. Inflation then eases back to a little above the 2.0% target in the medium term as the near term rise in energy prices drops out of the 12 month rate and capacity pressures moderate. Overall the risks around the central projection to growth lie to the downside while those to inflation are balanced.


The Bank of Japan left the overnight call rate at 0.5%; the vote to do so was unanimous. The bank last changed rates one year ago, when it added 25 basis points bringing the rate to 0.5%. It was then only the second hike of its flexible and gradual policy which started in July 2006 after a prolonged period of zero percent interest rates. The bank spokesman characterized monetary conditions in Japan as accommodative.