Stagflation Grips Eurozone

Stagflation Grips Eurozone As ECB Interest Rates Rise

By Ambrose Evans-Pritchard, Telegraph.Co.UK | July 2008

Eurozone inflation surged to an all-time high of 4% in June despite worrying signs of a slump in manufacturing, confronting the European Central Bank with the toughest challenge since its creation a decade ago. Soaring oil and food prices guaranteed the quarter-point rise in interest rates to 4.25% on Thursday, further widening the gulf in rates between Europe and America. The only question is whether the ECB opts for a "one-and-done" move or sets the course for yet more rises in the autumn.

Jean-Claude Trichet, the bank's president, has warned of an "acute risk" of a wage-price spiral unless inflation is wrung out of the system. But a growing chorus of critics fears that overkill could tip the eurozone into a severe downturn at this delicate juncture, and risk a dangerous chain of political events in southern Europe and Ireland— where voters have already thrown the EU into chaos by rejecting the Lisbon Treaty.

The Irish economy contracted at a rate of 1.5% in the first quarter and is now facing the worst recession since the crash of the mid-1980s. Investment fell 19.1%. House prices have now fallen for 15 months in a row. Spanish premier Jose Luis Zapatero was forced to reassure his nation's media this weekend that he was still on speaking terms with his finance minister Pedro Solbes, who has refused to endorse the government's economic crisis plan.

Both Mr Zapatero and Italy's Silvio Berlusconi have lashed out at the ECB in recent days, but even Germany's finance minister Peer Steinbrück has begun to question Frankfurt's hard-line policy. "An interest rate increase could have a pro-cyclical impact at a point when the economy is slowing down," he said. The comments come after five months of falling orders in Germany, the worst run since the early 1990s. Siemens, Volkswagen and other big industrial exporters have begun to cut jobs.

The ECB has held rates steady at 4% since the credit crunch began last summer, even though Euribor lending rates have jumped 120 basis points. The euro has rocketed against the dollar, sterling, yen and yuan. The full effects of the monetary and currency squeeze will slowly feed through the eurozone over the next year or so. There is a risk that the full impact could hit just as the global economy slows sharply.

France's finance minister, Christine Lagarde, praised the apparent policy shift in Berlin. "For the first time my German colleague, who was resolutely determined to back the ECB whatever it does, is telling Mr Trichet, 'Be careful'. There is more than one concern. There is inflation, certainly, but there is also growth. Quite a few of us would like Mr Trichet to keep his eye on both barometers. Until now he has had only inflation on his radar," she said.

Her choice of words is significant. EU ministers have the ultimate power— under Maastricht Article 109— to shape the eurozone exchange rate, giving them a backdoor means of forcing a change in the ECB's policy. The implicit threat to invoke this clause is a warning to ECB hawks that independence has limits.

The remarks by Paris and Berlin come as US Treasury Secretary Hank Paulson visited both Mr Trichet and Bundesbank chief Axel Weber. The Bush administration is reportedly furious with the ECB for undercutting US efforts to stabilise the dollar and halt the oil spike in very dangerous circumstances. The ECB is playing with fire, forcing the US to pursue a more restrictive monetary policy than it might think safe at a time when the financial system is already in dire trouble. The dispute has echoes of the Transatlantic rift before the stock market crash in October 1987.

Oil jumped $16 a barrel in two days earlier this month on the back of a rising euro after Mr Trichet merely signalled an ECB rate rise. The market response was a prize exhibit for those who argue that hedge funds have now run amok on the oil markets, using crude futures as a sort of "anti-dollar" currency— with multiple leverage. It also revealed that ECB tightening in this environment is counter-productive since it pushes inflation even higher. Critics say the bank is chasing its own tail, failing to adapt to the complexities of the modern global economy.

Stephen Lewis, chief strategist at Insinger de Beaufort, said the ECB was right to raise rates, despite the risks. "If they had backed off now after signalling a rise it would have caused a catastrophic loss of credibility that would further harm global stability," he said. "The bank cannot formulate policy on the basis that this might be a short-term price spike. It would destroy consumer confidence and blast economic growth prospects if it lets inflation run ahead."


News Item: Another Reason Mr. Trichet Hiked Rates On Thursday

In case you missed it, the euro pushed to $1.5775 last Wednesday, overnight 1 July. And as luck would have it, the European Central Bank (ECB) met on Thursday last week. Yes, while most of the markets' participants in the U.S. dreamt of barbequed ribs, fireworks, and a long weekend, the ECB hiked rates again by 0.25%.

The most important part of Thursday's decision was ECB President Trichet's press conference following the rate hike. It was important for Trichet to remain hawkish on the economy as otherwise, the profit takers would be quick to swallow up all momentum from the rate hike. And, as it happens, the euro didn't get to enjoy the higher rates for more than a few hours. Trichet cited risks to euro-zone economic growth while sounding dovish about additional rate increases. That outcome caused investors to buy dollars as positions were adjusted.

Late Friday, the dollar was trading at $1.5699 against the euro, compared with $1.5701 late Thursday, and was fetching 106.77 yen, from 106.74 yen. The dollar was also little changed against the pound sterling, at $1.9823 from $1.9828 a day earlier, and against the Swiss franc, dipping marginally to 1.0254 francs from 1.0266.

Meanwhile, Trichet received an arrow for his rate hike quiver. German unemployment for June fell to a 16-year low. This tells me, and should tell you, the barber, and the guy down on the corner selling bakery pretzels that Germany is resisting the global slowdown so far. Germany is the Eurozone's largest economy, so this report carries a lot of weight with Trichet and the other ECB ministers. Annual growth in Germany remains above that in the U.S. and the employment picture is healthier than the U.S.'s— but then again, that's not difficult these days.

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Normxxx    
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ߧ

Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.