Monday, June 9, 2008

Woeful error of judgment questions credibility of the ECB

On June 5th last, Jean Claude Trichet shook the world’s financial markets when he made what now looks like being his bravest statement since becoming ECB President, when he boldly signalled to the world’s media the ECB may raise interest rates when they meet again in July. To be fair to Trichet his statement was merely echoing the sentiment of the ECB’s Governing Council which had just deliberated on monetary policy for the 15-nation euro economic block. Markets were taken completely by surprise by the remarks as most Central Bank analysts had expected the next move in ECB interest rates to be down, albeit much later in the year. While inflation is running at a 16-year high in the euro zone, the recent surge in consumer price inflation is not because of excess consumption or demand from a slowing economy and an increasing cash-strapped euro area population, but rather because of a spike in global oil and commodity prices. These commodities are priced in dollars and only a rebound in the US dollar or some major global demand destruction is going to curb commodity price inflation. As to how the ECB believed a direct threat to raise euro zone interest rates exactly at the time the US Dollar was attempting to steer a tentative path to recovery is a mystery, but the record jump in crude oil prices witnessed in the 31 hours following Mr Trichet’s bombshell, would suggest the ECB’s strategy has backfired rather spectacularly already. Oil prices jumped a staggering $16.50 during this 31-hour period, or 13.5%, with oil futures posting lifetime gains on both Thursday and Friday’s sessions. The euro jumped 4 cents against the dollar over the same period and rose to its highest level against the yen in a year and this on a week when eurozone economic data added to growing evidence of a sharpening downturn in the euro area economy.

Spain’s Prime Minister, this past weekend, was correct to question the wisdom of Mr Trichet’s remarks and he essentially blamed the ECB President for the spike in oil prices seen at the end of last week. The nature in which the ECB ignored and steamrolled comments made by Fed Chairman Ben Bernanke earlier in the week, about the benefits of a stronger US dollar, does not augur well for a coordinated effort by the World’s Central Banks to solve the global inflation problem, a problem which is fast becoming a crisis. The ECB’s glaring lack of insight begs one to question the relevance and comprehensiveness of the data models used by ECB staff in making projections used in advising the Governing Council in its decision making process. A rate rise now by the ECB means higher inflation for the euro area, given trends and the driving factors behind the recent rally in commodity prices and this should have been known in advance of last week’s ECB meeting. As evidenced last Thursday and Friday, monetary policy which translates into a weaker dollar in the current climate means a disproportionate increase in fuel and food commodity prices for everyone, including all euro zone citizens. Why did the ECB Governing Council ignore this in its deliberation? The second round inflation effects that so concern the ECB is certain to become a self-fulfilling prophecy, if first round inflation is merely being fuelled by calamitous ECB monetary policy. This policy could trigger a vicious cycle that sees the ECB having to hike again and ultimately not only send the euro economy into a damaging recession, but it could lead to a major divergence in performance of the constituent states of the euro area. A divergence in performance will lead to greater political sniping and undermine not just the ECB’s credibility, but its very independence.

The ECB may feel it will lose face if it now fails to follow through with a July rate hike, having quite clearly signalled its new-found ‘heightened alertness’ last week. However, in light of the rapid evidence we have seen of how commodity traders have shown their willingness to translate this ‘heightened alertness’ into ‘heightened price inflation’, it means if the ECB is to follow through with this ill-timed threat, it may well constitute the most serious ‘dearth of alertness’ ever displayed by an ECB Governing Council, one for which all euro area inhabitants could pay very dearly, for some considerable time to come. Many would ague they are already paying too much.

Ted B


Anonymous said...

Why can't there be a larger divergence between the dollar denominated price of oil vs. the euro denominated price ?

That is, isn't it possible that ECB is trying to force a tighter couplinng of oils rise to the dollars fall ?

If so, wouldn't that help them in the way they (theoretically) would like it to help them ?

Unknown said...

The problem is the ECB don't know to what extent oil prices are being driven by a strong euro/dollar as against supply and demand fundamentals. I also don't think they are interested in knowing and the only pill they seem capable of prescribing for higher inflation (regardless of the source) is hawkish rhetoric and higher interest rates. Lower interest rates in this instance would in fact lead to lower oil prices and the ECB could justify it on the basis the euro economy is slowing and longer run inflation expectations should moderate.

The ECB clearly decided last week that the oil/dollar problem was one of the Fed's making and it is up to the Fed to do something about it, not the ECB. The Council effectively gave Bernanke a slap in the face. After hearing Hank Paulson's speech yesterday and Bernanke's hawkish tone last night, it does look like the Fed has been pushed into a corner and is trying to retaliate verbally. It looks today like someone is listening but we know these markets can turn quickly again, so it will be interesting to see, if it does come to it, is the Fed or the US Treasury going to follow through on the threats, and actually pull a few punches.

I personally believe that the spike in oil prices last Thursday and Friday might have fatally damaged the case for oil bulls to push the price much higher. It is now abundantly clear, even to the dogs on the street, that the rapid run-up in the price of crude has little to do with real economic fundamentals of supply and demand, but is driven by opportunistic greed. The downside could be vicious when the turn actually comes.