Trichet Retains Hawkish Tone

September 4, 2008

The ECB’s balancing act goes on.  However, whereas the August press conference dwelled on the weakness of growth more than had been anticipated, today’s press conference and statement returned the source of greatest concern to the unacceptably poor inflation outlook.  A restoration of price stability, that is below but close to 2.0%, is not expected by officials until 2010.  The range for projected CPI inflation next year shows a higher mid-point of 2.6% versus 2.4% in the previous forecast made in June, and it is entirely above 2.0% at 2.3 – 2.9% versus the old band of 1.8 – 3.0%.  Language used to describe unit labor costs (“sharp increases”) reflects increasing ECB concern and protest.  Related to this, Trichet concedes that selected second-order inflation effects have surfaced.  This is the development that officials have dreaded openly about for more than a year.  So far, second-order effects have not become broad-based, but Trichet served notice in tougher terms than before that “we are resolute in our determination to keep medium and long-term inflation expectations firmly anchored.”  In Q&A, the ECB president kept the message from August that officials do not have a bias about future policy but added that it has been only since July that rates were hiked, a move felt to be necessary to bolster credibility.

It seems premature of markets to anticipate an ECB rate cut later this year or even in early 2009.  The baseline CPI range that the ECB envisages for next year lies entirely above the target ceiling of 2.0%, and risks surrounding that prediction are skewed to the upside based on both the bank’s analysis of economic data and its study of monetary and credit growth trends and levels.  To be sure, those risks could moderate in time.  Commodity prices may not turn back upward.  Moderation seen already in money and credit growth could pick up speed.  Gauges of expected inflation based on traded futures and other data may settle back, and wage awards could develop in a more acceptable way than officials fear.  That’s a lot of ifs that will take time to verify.  To be sure, Trichet and his colleagues expect inflation to dip back under 2.0% by 2010, but that is too long an interval to merit policy action at this time.

A month ago in August, ECB officials admitted that real GDP had weakened in mid-2008, which was a downgraded assessment from July’s assertion that activity “remains broadly in line with our expectation of moderate ongoing growth.”  The assessment was downgraded again today to “experiencing an episode of weak activity.. ”  Without using the R-for-recession word, new growth forecasts clearly embody that possibility.  Projected 2008 growth was cut 0.4 percentage points (ppts) to 1.1 – 1.7% from 1.5 – 2.1%, and the predicted range of outcomes in 2009 was sliced by 0.3 ppts to 0.6 – 1.8% from 1.0 – 2.0%.  Moreover, risks surrounding these baseline ranges are still skewed to the downside, meaning a sub-zero average rate of growth is far from being out of the realm of possibility.

The ECB will not wait until CPI inflation is 2.5% or less before cutting interest rates.  But I believe officials will hold their fire at least until 2009 and not act before they are confident that core inflation is on a sustainable downward course.  They already have resisted any urge to act at the first sign of recession.  Odds of back-to-back quarters of negative growth climb day by day.  July’s Euro-zone volume of retail sales was already 0.8% lower than the 2Q level, which nearly matches the 2Q-over-1Q drop.  The composite PMI has moved below 50.  Consumer confidence is very depressed, business sentiment is worsening more sharply, construction is in full crisis in several members of the bloc, and export demand is becoming increasingly depressed.  The declines in the euro and oil are not yet far enough to deliver immediate or sufficient relief.  Real German orders slumped 3.8% (14.4% saar) in 2Q and were another 3.8% lower in July than the 2Q mean, and domestic orders for capital goods, a harbinger of German business spending in coming months, posted monthly drops of 1.8% in June followed by 3.9% in July.  Only an eternal optimist would think Euroland will avoid recession.  The ECB policymakers are not eternal optimists.  Sometimes a recession is what it takes to restore stable prices.  Sometimes a recession is exactly what monetary officials believe they are supposed to promote.  Former Fed Chairman Volcker waited a full 12 months into a very deep recession before starting to loosen America’s extraordinarily tight monetary policy in mid-1982, and that’s not the only historical example that proves this point.

Many market pundits have been critical of the ECB, contrasting its inertia with Bernanke’s quick and aggressive easing, which averted negative U.S. growth in 1H08.  Such pundits assert that currency markets are now punishing the euro in response, and that ought to be a fine consequence with ECB officials. Monetary restraint, in their opinion, had been too heavily concentrated in an overvalued euro and not sufficiently represented in the level of interest rates.  The euro’s slide since mid-July helps reorder that imbalance.



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