ECB Concedes Growth Weaker Than Assumed

August 7, 2008

The ECB as expected kept a 4.25% refinancing rate and asserted that information since July’s 25-basis point rate increase justify that hike.  None of this is surprising.  I cannot recall any central bank, let alone the proud ECB, ever admitting one month after a rate change that it had acted in error.  Points made about inflation and the outlook for inflation were standard and revealed little new thinking.  Market participants were reminded that medium-term price stability is the ECB’s primary objective and that anchoring expected inflation is a crucial condition for achieving that goal.  Price risks are skewed to the upside on a baseline forecast that envisages continuing inflation well above the 1.9% target ceiling for the rest of 2008, and only a gradual moderation from 4%-plus will materialize in 2009.  The danger of second-order price pressures is underscored by a deceleration of labor productivity and indications of faster growth in labor costs in recent quarters.  Monetary analysis also points to medium-term threats to price stability.

Bund yields and the euro fell as the press conference was held, nevertheless.  While there is no hint of a near-term cut in rates, officials made for the first time the concession that growth at the cusp of 2Q08 and 3Q08 year looks weaker than anticipated.  The admission was made indirectly by saying weakness only partly represents a technical response after temporary factors buoyed growth in the first quarter.  Slower global growth and the effects of higher food and energy prices have also dampened growth.  The official line remains that the third quarter will also experience weak activity but that conditions will improve in 4Q.  Interestingly, officials did not present a list of factors likely to buoy investment as they have done routinely in the past, suggesting that they have doubts about that key demand component as well as about personal consumption.   Data for the fourth quarter will not emerge until very late this year, ruling out a rate cut in 2008.  In the meantime, several other variables will affect policy in 1H09, including whether inflation tops out or keeps cresting, the future behavior of labor costs and negotiated wage deals, future developments in food and oil prices, and the degree of softness in global and regional economic activity.  ECB officials will have to weigh the further evolution of the global financial crunch and whether emerging markets prove to be as resilient as they presently assume.  The euro is not likely to influence policy.  It’s fine if it stays above $1.50 as that will counteract inflation, but it’s also fine if its retreat extends into the 1.40’s or lower, because the euro is currently extremely overvalued by objective standards.  According to the Big Mac Index, calculated and reviewed annually by the Economist, the dollar is 50% overvalued relative to its $1.06 per euro implied purchasing power parity for a Big Mac.  By contrast, dollar/yen on such a basis is presently 27% undervalued.

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