Will the ECB Manage the Transition from Expansion to Stagflation?

by: Macro Man

The second law of thermodynamics states that entropy always increases. Put another way, "things change." How one reacts to changing environments can often make the difference between long-term success and failure.

Thursday's Olympic relay action clearly demonstrated the dangers of taking a cavalier approach to changing circumstances. The abject failure of the US 4 x 100 relay teams (and indeed, the GB men's team) to manage the passing of the baton as leg-runners changed provides an object lesson in the importance of managing change well.

From Macro Man's perspective, the tone of the markets that he trades has changed markedly over the last couple of weeks. In contrast to the equity market crack addicts, he actually had a pretty reasonable run in July and the first week of August. Midway through his holidays, however, the tone of the market appeared to change, and he found it increasingly difficult to make money even where he was "right."

To Macro Man, this represented a change in market environment from one in which he was well rewarded for being right to one in which he was badly punished for being wrong. The way that he manages money is alterinig his style when the market tone changes; by dialing down the risk level and trading more tactically when things get difficult, he tries to avoid dropping the baton and giving P/L back too cheaply. And frankly, after a stressful holiday, dialing things down gives him a valuable mental respite.

Another set of people who need to focus on not dropping the baton are the world's central bankers. The Fed gathered for its annual brainstorming session at Jackson Hole Friday, and you'd have to think that they'll give quite a bit to thought on how to navigate between the central banking Scylla and Charybdis of higher energy prices and lower growth.

Not that the Fed is alone, of course; most other major central banks face a similar dilemma. Q2 growth in the UK, for example, was revised down to zero on Friday, yet headline inflation is at fifteen year highs. Recent comments from the ECB suggest that they don't see much risk of a European recession, which leads Macro Man to wonder if they're bothering to look. Certainly the ECB officials from the PIGS can see the risk by simply looking out their front windows.

Yet the appropriate monetary action isn't clear. Bernanke has found to his chagrin that the Greenspan model of slashing rates willy-nilly carries substantial negative externalities. Yet it's not altogether clear that the European "financial Calvinist" approach is markedly superior. It wouldn't be a surprise to see Mervyn King start wearing a toga, as he resembles nothing so much as Nero fiddling while Rome burns.

The ECB, meanwhile, delivers a monthly lecture on the perils of second-round effects while appearing oblivious of the possible negative externalities from their own hawkish rhetoric. What's ironic is that despite the rise in European headline inflation, domestically-generated inflation pressures have been remarkably stable. The chart below shows the GDP deflator for a number of economies; observe how the European measure has flatlined for the better part of five years around the ECB inflation target of 2%.

Should the European economy continue to lose momentum, as seems likely, these domestically-generated inflation pressures should eventually recede, as they have in the United States. A monomaniacal focus on headline CPI from the ECB will, in the fullness of time, unnecessarily reduce the living standards of those 320 million Europeans whose interests M. Trichet claims to hold close to heart.

Whether the ECB can manage the transition from expansion to stagnation without dropping the baton will be a critical driver of financial market pricing over the next few quarters if not years.