What Is the ECB Smoking?

As the Greatest Financial Crisis Since the Depression rolls on, complete with continued carnage at the front end of most major yield curves, the divergent views of prominent central banks is coming increasingly into focus. While Fed policy remains extremely easy (as measured by real rates) and the Bank of Canada cut rates yesterday, seemingly not a day goes by without a hawkish comment from an ECB member. Given the apparently universally held view that a) the European banking system is buggered, b) that stuff like Spanish property is in free-fall and requires attention, c) weak sisters like Italy are being crippled by the strength of the euro, and d) as a result, European growth is headed for a massive slowdown, a constant refrain that Macro Man hears from colleagues and counterparties is "what is the ECB smoking?"
Macro Man did a bit of digging to find out. We should recall that the ECB's mandate is to ensure price stability, with the primary definition of this defined as CPI inflation close to, but not exceeding, 2%. Regular readers of this space, or indeed observers of financial markets, will know that the ECB has not achieved this goal in a long time, as demonstrated by the chart below. Now obviously, headline inflation (the object of the 2% target) is being higher by energy prices, and frankly there's not a lot the ECB can do about that in the short term. That having been said, we should recall that the ECB dialed down the rhetoric late last year on the expectation that inflation was experiencing a temporary "hump". Nothing that we've seen so far this year, least of all $119/bbl oil prices, suggests that we're about to coast down the downside of that hump.

More worrying, from the ECB's perspective, is the potential for second-round effects- namely, rising wages that then fed through into broader price rises. In fairness, macroeconomic data on wages has been pretty muted this far. Worryingly, however, core CPI has risen steadily over the past couple of years, and now rests at the ECB's 2% target for headline! If that isn't evidence of incipient second-round effects, Macro Man isn't sure what is.So will second-order effects intensify? One place to look is labour markets to get a gauge of tightness. And there, the message is that European labour markets are very tight indeed. In Germany, the "anchor" or "daddy" of the Eurozone, has seen its unemployment rate fall to the lowest level since immediately after unification.
And what of serial moaners France, who can almost always find something to complain about- be it the level of interest rates or the level of the euro? As one of Macro Man's colleagues observed this morning, the chart below looks like a classic head-and-shoulders formation: a bearish pattern suggesting that the line should head lower. In point of fact, it's a graph of France's unemployment rate, which is at 25 year lows. That bears repeating: French unemployment is at 25 year lows! You can just imagine the memo that Trichet and co. composing a memo to the French Finance Minister. "Dear Mme. Lagarde: Shut the f*** up!"
But enough of the core: what of the periphery? The market is replete with stories of collapsing prices for Spanish coastal properties, which inevitably drag the economy down with it. How valid are these fears? As far as Macro Man can see, not nearly enough to alter the ECB's calculus. Spain's own house price index , recently updated for Q1, has yet to show a quarterly decline this decade. Sure, the price of some coastal properties is falling.....but its hard to see the ECB (whose own Frankfurt homes haven't budged in value over the last few years) having much sympathy for British owners of vacation homes, who in any event are benefiting from the currency move!
And finally, what of Italy, particularly now that Signore Berlusconi, his fake hair, and fake tan are back in charge of Italy's government? It's taken as gospel that Italy is getting squeezed by the strength of the euro, and indeed that Berlusconi will moan about it. On the latter issue, Macro Man has no doubt that Berlusconi will indeed raise a stink. On the former, colour Macro Man unimpressed. The chart below shows the rolling twelve month sum of Italy's trade balance. He cannot help but notice that despite the sharp rise in oil prices over the last couple of years, the trend in Italian trade (supposedly crippled by the euro) has actually improved. Cry me a (Tiber) river, Silvio.

So what are we left with? Prices that are too high and threatening to stick. Historically tight labour markets. Few obvious signs of macroeconomic stress in supposedly vulnerable Club Med countries. Rather than asking what the ECB is smoking, Macro Man can't help but wonder what the market is smoking for thinking the ECB shouldn't hike.

Comments

[Nepzone]

I think the ECB is the only major power doing a admirable job in analysing economic data & a good job in containing inflation.

Many central bankers are only helping fan inflation, especially the US FED.

Let's be serious, if we are really in the Greatest Financial Crisis Since the Depression, the DJIA chart surely does not reflect this crisis at all. The DJIA is not very far from it's all time high, and the current crisis is even less severe than the Sept 11 Bombing.

As such, the US FED is using this as an excuse to help bail out friends on wall street and in doing so fanning the next big bubble.

Let's put things in perspective, the current financial crisis is only affecting Corporations that were greedy, thru their greed they failed to institute & practice safe lending practices. Home owners loosing their houses now probably shouldn't have qualified for a home loan in the first place if banks were not so greedy!!!

And the FED using all sort of excuses, jumped in to help their friends on wall street.

Let's be serious, IBM and so many other companies are still posting profits (not losses). So how can this be the Greatest financial crisis?

Don't take my word for it, just look at the DJIA chart

[User 143167]

There is nothing wrong for ECB to stick to its mandate.
Seems the Fed and probably the most US people are still in this illusion that "easy monetary policy will cure all".
It is just laughable if you believe "the problem caused by easy credits can be solved by injecting more credits."
If, and only if, the US dollar is not a global reserve currency, this credit crisis in the US will have made US become the next Japan already. But last time I check, Euro is still not a global reserve currency so that's not a viable option to them.
"It is our money, but it is your problem!" How true is that! God bless the $$$!

[Joe]

Macro Man is right in many ways, for instance Italy.
Before the Euro the Italian Lira was in permanent decline,
a symbol of long - term inflation. The constant Lira devaluation was
the useless attempt to undo, "transmogify"... all sins of politics
(scandals, scandals, ... incompetence, negligence, .. just name
it).
A glimpse on that can for instance be gained in entertaining
literature: Donna Leons' crime stories, all placed in Venice
(lucid reading).
The same attempts of cheating are correctly diagnosed in France.
Yes, yes, .. to all what is said above.

[warrenmosler]

mainstream economics says:

get inflation right and that 'automatically' optimizes long term growth and employment.

adding to demand with a negative supply shock turns a 'relative value story' into an 'inflation story.'

the ecb is following mainstream theory, while the fed is not.

why?

the fed sees looming systemic, deflationary tail risk at the door. at least up to now.

the panic of 1907 and the early 1930's deflationary collapse- both previous examples given by the fed- were gold standard events.

with a gold standard (and/or other fixed rate regimes) there are direct supply side constraints on the reserve currency. interest rates are market determined, and during a credit crunch rates spike higher 'automatically.' even the tsy must fund itself and faces the same supply side constraints, thereby limiting fiscal responses. This continues in today's fixed fx currencies.

with floating fx/non convertible currency there are inherent no direct supply side constraints on bank lending, deposit creation, and credit in general. any constraints are on the demand side, including financial capital where constraints are also on the demand side. the cb necessarily directly sets rates, not market forces, and govt. spending is not constrained by taxing, borrowing, etc. hence fiscal packages are subject only to political choice.

today's risks are much the same as previous financial crisis type risks like 1987 and 1998, where the govt and its agencies have the open option of 'writing the check' as desired, with inflation the price to pay, not govt. solvency as with fixed fx regimes.

just like the 70's, the saudis are acting the swing producer and setting price and letting quantity they pump adjust. this is also necessarily the case when one is single supplier at the margin with excess capacity. the alternative of pumping flat out and hitting bids in the spot market is not a functional option for any monopolist. only price setting is.

russia is also a monopoly supplier at the margin, and probably is also acting as a swing producer. so crude prices go to where the higher of the two set them.

mainstream theory hasn't yet publically addressed this kind of negative supply shock.

one option is to match the domestic inflation rates to the price hikes to try to avoid declining real terms of trade.

this is both politically impossible and it can quickly lead to accelerating inflation.

we have two choices, neither particularly attractive:

watch our real terms of trade continue to collapse as crude prices are continuously hiked.

try to inflate to moderate the drop in real terms of trade.

ironically, we will chose the later as we did in the 70's because inflation is not a function of interest rates in the direction cb's subscribe to.

increasing nominal rates increases inflation via the cost and demand channels.

costs of holding inventory and investment rise with rate hikes.

govts are net payers of interest to the non govt sectors, so rate hikes also increase govt spending on interest to support incomes in the non govt. sectors.

good luck to us!

warren mosler

moslereconomics.com

[fxtrader07]

the author starts with wrong assumptions in the first place. the ECB has not lowered rates, yes, but it has provided much faster and much more liquidity to banks than any other central bank in the world right after the crisis started to build. lowering rates will do little to help european banks as the cost of funds is not the major issue currently. even in the u.s. the lower rates do little to adress the core problems except that they support the housing and mortgage market, e.g. by preventin a resetting of mortgages at way higher levels.
The euribor is already 80 basis points ABOVE the ECB lending rate - so lowering the target rate will not make much of a dent. then, the ECB was so far correct in anticipating that the economy stays quite strong and that inflation stays high. It could be argued that higher interest rates will do little against rising global commoddity prices (Chindia demand), the major part of the price rise. However, they keep the euro rising which at least curbs the effect of oil 118$ to some extent.
And then: the fear of darmageddon might turn out to be pretty much overblown. The ecb is right in NOT risking their credibility by fighting one of many plausible future economic scenarios that in fact may never materialize anyway only to end up like Easy Al with his infamous y2k-monetary stimulus. and we all know how THAT one played a great role in engineering a finacial market collapse

[sivere]

The problem is the $500+trillion derivatives bubble that may pop at any time. This is all the fault of the Fed and other central banks- including the ECB and their policies of the last 20 years (at least). As the derivative bubble was inflated the central banks stood by, even encouraged it with glee. In fact in the US at least, it is the fault of congress who have the constitutional responsibility to administer and maintain a currency and system of credits. Therefor, we need to

TakBackTheFed.com

We need to do it NOW. Let's not sit around and wait fo the crash, open our wallets, and pay for it (not that what is in our wallets will necassarily be woth much). Let's take action now, and save our nation! Let's do so in consultation with the ECB and other allied central banks.

[Rob Spooner]

So the last time he checked, User 143167 did not find the Euro to be an international reserve currency. Keep checking. The shift will be a process, not a moment in time. The United States has abandoned all pretense of fiscal responsibility. In the face of a huge federal deficit, the President has shoveling money to the taxpayers that he will have to borrow. Two of three major candidates to succeed him, in the face of demand for gasoline that exceeds supply, want to worsen the federal deficit in order to increase demand.

The world is getting tired of this. Not overnight, but they are getting out.