A rate rise, plus a neutral bias – a typical European compromise

 

It is beyond us how people managed to find surprise in yesterday’s press conference by Jean Claude Trichet. As everybody expected, the ECB raised interest rates by 0.25%, and this dutifully reported by every newspaper in Europe. Trichet did not pre-announce another rate rise, which was clear as well, and he went out of his way to say that the country bias in policy is neutral – which is the price the doves extracted for accepting this rate increase. The euro nevertheless fell against the dollar from $1.59 to $1.57, and global equity markets recovered, for reasons that can only explained by the warped logic of those markets.

 

During his Q&A session, Trichet said the rate rise should serve as a signal that the rise in inflation should not be used as an excuse to negotiate higher wages, or as an excuse to raise goods prices. He expressed concern about wage indexation (more about this below). Interesting also, he effectively signalled that there will be no more code words.

 

There was much predictable reaction. In Germany, for example, the head of the large service union Verdi fiercely attacked the ECB, saying it would kill off the economic recovery.

 

 

 

ECB not alone: Riksbank also raises rates

The Riksbank has been the first of the major central banks to raise interest rates after the onset of the credit crisis, the FT reports. It has done so again yesterday, raising a quarter point to 4.5%, and unlike the ECB the Riksbank says more rate increase may be necessary to bring inflation down from 4% to the target of 2%. The two central banks face approximately the same circumstance, except that the Riksbank appears a touch more serious in trying to hit its inflation target than the ECB, where there the governing council is deeply divided.

 

 

Trichet’s oil rally

This term is not our invention, but from Barry Ritholtz, who has made the observation that when the ECB raises rates, the dollar falls and oil rises. This has now become a popular line among ECB opponents. So by that logic, the ECB’s monetary policy is the deep underlying cause for the rise in global oil prices. A small flaw with this argument was apparent yesterday, when the dollar rose against the euro, and the oil price rose nevertheless.

 

 

Trichet’s collateral policy

We did not think Trichet was trying to gives us hint, but the Wall Street Journal Economics Blog read more into than we when Trichet said about the ECB’s collateral policy: “If it is necessary to refine elements in our scheme, we shall see what we have to do.” The ECB has been criticised for accepting too much junk paper, and has come under pressure to tighten the collateral rules.

 

 

 

Why European inflation is so sticky?

Frankfurter Allgemeine has an interesting article about prices indexation in the euro area. In Belgium, Luxembourg and Spain price index systems are customary for most wages. In Belgium, almost all wages are indexed to a core-inflation measure. In Spain, two thirds of employees have index clauses in their contracts. It is no surprise therefore that those two countries have the highest inflation rates in the euro area. Belgium had an inflation rate of 5.1% in June, while Luxembourg and Spain had 4.8 and 4.7% respectively. In other countries there is no indexation, but inflation thresholds above which employees are compensated. This is the case in France. There is an automatic indexation of minimum wages in France, Malta and Slovenia. In five countries, mostly importantly in Belgium, the public sector wages are inflation indexed.

 

 

Calls for a wider ECB mandate

It was clear that policies of inflation target would only be popular for as long as inflation is low. Once it goes up, there will be pressure on central banks to change the target. El Pais, very obviously speaking from a purely domestic standpoint, advocates a change in the ECB’s mandate away from a pure price stability objective, to reflect, as the editorial puts it, that people’s wellbeing is determined by a more complex set of goals. (While that is obviously true, the question remains whether a central bank should optimise people’s happiness through interest rates, the only tool it has available).

 

 

Calls for a higher inflation target

An alternative go-soft strategy was proposed by Thomas Fricke in FT Deutschland, who says the ECB is not going to hit its 2% target in any case, as this target was set at a time when global inflation was 1%. He looks at historic inflation performance by the Bundesbank, and found an average inflation rate of 2-3%. He says this would be a reasonable target for the ECB to adopt as well.

 

 

 

Kaczynski wants leadership role

In a Polish TV address, president Lech Kaczynski said his refusal to sign the treaty came out of a desire to play a leadership role in the EU, in particular for Poland to act as a protector against small countries like Ireland. He said the only way for the Treaty to be ratify is for Ireland to change its mind in a second referendum. Prime minister Donald Tusk’s party is now planning a motion in the parliament to force the president to sign the treaty, Frankfurter Allgemeine reports.

 

 

An interesting statistic

Eurobarometer has found that the number of Europeans in favour of nuclear power has risen strongly, from 37 to 44% over the last three years. A further 39% says they would be in favour if there was a permanent solution of the storage of nuclear waste, according to Frankfurter Allgemeine

 

 

Some analysis on price-to-rent ratios

No matter how you look at the US (or UK, or Irish, or Spanish) housing markets, the degree to which they are (still) overvalued can gathered from looking at a variety of indicators. The most simple is the long-term trend in real prices, which is a very rough indicator, which shows that in the US we are still not on the halfway mark of the total peak-to-trough price declines. The Calculated Risk blog has done some number crunching for the price-to-rent ratio, which should be a mean-reverting series, as people could always react to a rise in house prices by renting relatively more cheaply. This series has been stable for a long time, hovering around an index level of 1, going up to a level of 1.6 (on the Case-Shiller measure), and is now back to 1.3. This suggest that we are about half-way through (less the market overshoots on the way down).

 

 

The difference between the French and the Irish property markets

Brendan Keenan in the Irish Independent takes up Christian Noyer’s remark that there is a crucial difference between property markets where lending is based on ability to service the loan (like France) and where it is based on bets that the value of property will rise. While France had a property boom too with prices rising by more than 200% over the last decade compared to over 300% in Spain and Ireland, the difference is that almost all home loans in France are on fixed rates, which makes the market less vulnerable than those which are based on variable rates.  Keenan argues that the Irish government could have done more to encourage fixed rates mortgages, i.e. using tax breaks or mortgage relief or establish a stabilization fund.  But sadly, even the new government is in danger to do nothing about it.

 

 

The future of CDS

The FT has an interesting discussion about the future of credit default swaps, a $62 trillion segment of the financial market, that dwarfs the global stock market. More and more analysts think that this market has tested its limits. CDS prices used to be regarded as an accurate measures of spreads, so that a quotation of, say, 1000bp, would suggest that the company would have to pay this amount over Libor, to obtain funds. The article quotes the example of an Icelandic bank that has obtained much better conditions than its CDS price suggested. The agreement among analysts is that CDS are still useful, but mainly for large and liquid bonds.

 

 

John Thornhill on Nicholas Sarkozy

John Thornhill has an insightful commentary in the FT about Nicholas Sarkozy. He says that three things stand out: Sarkozy does not generally give the right answer, but at least he raises the right questions. He is an instinctive dealmaker. And there may be method in his madness. He quotes a think tank’s analysis that Sarkozy may already have delivered on 60% of his election promises. He also makes the point that Sarkozy is at least trying to raise some fundamental questions about the future of the EU after the Irish referendum.

 

 

 

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