Frankfurt: On Monday, 21 January, Federal Reserve chairman Ben Bernanke abruptly cancelled plans to travel to New York so he could stay in Washington to engineer the largest one-day reduction of US interest rates in recent history. His counterpart at the European Central Bank (ECB), Jean-Claude Trichet, did not change his plans that week—for travel or monetary policy.
Taking care to give ECB a heads-up before the public announcement, Bernanke sharply cut the Fed’s benchmark lending rate by three-quarters of a percentage point early the next morning, partly in response to plunging global share prices.
The next day, with Europe weathering similar market turmoil, Trichet coolly told the European Parliament in Brussels that the bank, which has its headquarters in Frankfurt, would keep rates steady despite the Fed’s move. “There is no contradiction,” he said later that week, “between price stability and financial stability”.
The contrasting ways the two responded to the crisis in the markets this year reflect something more than the differing economic and financial conditions in the US and Europe at the time. At a more fundamental level, they reflect surprisingly different views of how each economy responds to the underlying forces affecting growth and inflation. The Fed’s legal mandate, balanced between fighting inflation and encouraging full employment, leads to a simple investor calculus: If growth sags, the central bank is virtually certain to cut interest rates.
Not identical: ‘The US economy is not the European economy and both sides of the Atlantic are not in the same situation,’ European Central Bank president Jean-Claude Trichet had said in February.
Usefully for the Fed, which seems likely to cut its benchmark rate below its current 3%, inflation in the US tends to fall as demand slackens during a slowdown. And even though inflation has lately been rising to worrisome levels, the Fed appears to be counting on that tendency to apply again.
ECB, by contrast, is sceptical of the notion that inflation in Europe automatically falls when growth cools, and it has a mandate, inherited from Germany’s Bundesbank, to keep prices stable above all else. So the view from the Eurotower, ECB’s sleek, silvery headquarters, is very different from the Fed’s Washington perspective, whatever market participants may believe about the inevitability of lower European interest rates this year.
Trichet is likely to drive home this point after the central bankers emerge from their monthly meeting on Thursday, where they are expected to leave its benchmark interest rate at 4%.
Many investors are still convinced that the European central bank has little choice but to follow the Fed’s lead, if only to insure that recessionary conditions do not leech into Europe. Investors have bet that ECB will lower its benchmark rate this year, certainly by June, and possibly earlier.
The rise of the euro, which breached the $1.50 (Rs60.45) threshold last week, also augments the pressure on Frankfurt from some European politicians to at least hint at lower borrowing costs. Falling rates in the US have exerted a powerful force on the currencies by dampening the appeal of dollar-denominated assets.
“In the present circumstances, we are concerned about excessive exchange rate moves,” Jean-Claude Juncker, the Luxembourg Prime Minister who is chairman of the group of 15 euro-zone finance ministers, said on Monday.
But what is alarming for some politicians is raising far fewer hackles inside the Eurotower because the euro’s rise also helps curb inflation by lowering the cost of imported goods. Providing the euro’s appreciation is smooth, its rise feeds the logic of ECB’s decision so far to stand pat.
At its core, the disconnect between market expectations and declared ECB intentions stems from the bank’s failure— nearly 10 years after it was created as the steward of the euro, now a currency in 15 European nations—to emerge from the shadow of the Fed.
“Markets tend to put a very high correlation on Fed interest rates and European interest rates,” said Klaus Baader, chief Europe economist at Merrill Lynch and Co., and one of a minority of European bank watchers who said he believed it would keep rates steady all year. “That was the case when European monetary policy was driven by the Bundesbank and it is true now,” Baader said.
While ECB could well end up lowering rates if conditions change significantly, it is struggling over how to change the perception that a European rate cut is inevitable.
Consider what happened when its rate setting council gathered behind closed doors in Frankfurt on 10 January. At that point, its members—the six top bank officials and 15 national central bankers—found themselves embroiled in a lively and previously undisclosed debate linked to market expectations.
They had already decided to leave rates steady at 4%. Because of rising energy and food prices, inflation was running at about 3%, a level well above ECB’s goal of keeping the overall European inflation rate under 2%. But the council members were wrangling over a proposed draft statement that included the threat to act “pre-emptively” if European labour unions tried to embed higher energy and food prices into new contracts.
Trichet has long held that central banks do their best work when their threats to raise interest rates can deter inflationary actions in the first place, avoiding the need for excessive swings in the benchmark rate, so the line fit well with his own thinking.
The central bankers had already agreed that they had to offer a slightly more downbeat view of the euro area’s growth prospects in the closely watched opening paragraph of its monthly statement. Turmoil in financial markets showed no sign of ending, and with every passing day, the risks rose that banks would constrict the flow of credit to the real economy, endangering everything from business investment to consumer spending.
ECB officials knew that a message about slower growth would inevitably fuel speculation that it was opening the door to lower rates, even though its message about inflation—a far more telling indicator of the bank’s intentions —had not budged. So, against the wishes of some council members, the threat went in to help counterbalance the message on growth.
The episode is widely viewed as a communications flop, and the word “pre-emptively” disappeared from the next month’s statement.
“In my view, this was a pretty clumsy move,” said Charles Wyplosz, a professor of international economics at the Graduate Institute in Geneva.
But for all the awkwardness of the statement, it does reflect the view inside ECB that strong employment protections coupled with powerful labour unions and generous social benefits act as a brake on falling demand. And if higher inflation is being imported via high commodity prices, the lesson is that a mechanistic link between lower growth and lower inflation cannot be taken for granted.
Moreover, the ups and downs of the European economy—the distance it travels between strong growth and severe downturn—has been much less than in the US.
“The US economy is not the European economy and both sides of the Atlantic are not in the same situation,” Trichet said last month.
After the twin shocks this decade—the end of the Internet boom and the 11 September 2001 terrorist attacks—ECB never lowered its rates as far as the Fed, which went to 1%. Nor did it tighten as far as the Fed when times got better.
“The ECB never followed the Fed on the upside,” said Elga Bartsch, chief ECB economist at Morgan Stanley. “They never lowered as far and they never got into restrictive territory the way the Fed did, so all these notions that the ECB has to follow the Fed are misguided,” Bartsch said.
That history did not stop investors from lurching to the conclusion, in early February, that a rate cut in Europe might be imminent.
By the time of the European bank’s 7 February meeting, the outlook in Europe had dimmed somewhat, with real-time indicators showing a slight softening. That made any threat of a rate increase untenable, the council members concluded. Nonetheless, at his monthly press conference, Trichet again underscored ECB’s determination to focus on inflation.
“We have only one needle in our compass,” Trichet said, “which is that we have to deliver price stability.” Despite the balanced message, financial markets bid up the likelihood of a rate cut, with some daring traders speculating it could come as early as March. That led Trichet, by then in Tokyo for the meeting of Group of Seven finance ministers and central bankers, to remind the financial world that not one central banker at the last meeting in Frankfurt had been calling for lower rates.
“We had no call for an increase of rates, but we had no call for a decrease in rates,” Trichet said. “So, I would think that it is important that the two messages be fully understood.”
©2008/THE NEW YORK TIMES