What to make of the ECB's hawks

Central banks have hawks and doves on their boards, something that has always been, and always will be, the case. Two of the ECB's most hawkish members are the Jurgen Stark, a member of the ECB executive committee, who is in charge of monetary policy, and Axel Weber, president of the Bundesbank. They have both effectively signalled that European interest rates may be going up. How seriously should we take these warnings?

 

Stark's view is that the economic momentum of the euro area is underestimated, and that the effect of the credit crisis is widely overestimated. The ECB's economic analysis is generally very good, in fact probably the best out there at the moment. So we actually believe the first part of his argument, that the euro area good has been performing very robustly right until the third quarter. If Stark was right with his analysis, that would indeed amount to a solid case for another rate increase, or even two, under normal circumstances.

 

Now, we would not have expected the credit crisis, which only became a crisis in August, to have had any effects on growth in Q3. As far as the economic effects of this crisis are concerned, we do not expect the ECB has any superior information or insight. We know that the ECB is just as perplexed about the credit crisis as everybody else, and Stark is merely expressing his own view - which may well be right.

 

Unlike Stark, however, we remain convinced that the credit crunch is a serious event for the global economy. It is not primarily a subprime crisis, even though this is the sector where it started. This crisis may even go away for a few months, before it will resurface in some other sector, for example in the market for syndicated loans, which is going to be hit, once corporate bankruptcy rates are rising from the current low levels.

 

We also take the view that the US economy will suffer a very serious economic downturn, perhaps even a recession, over the next 18 months, and that this will transmitted to the rest of the world through a variety of channels - the exchange rate, direct demand effects, and the financial markets being the most important in the short run, and protectionism the most important in the long run. The idea that especially the euro area can disassociate itself from this global trend, is in our view not very credible.

 

The strong economic growth in the euro area would certainly have justified a rise in interest rates, but the prospect of a global slowdown and the rise in the euro's trade weighted exchange rate makes this unnecessary. If the ECB were to raise interest rates, which would come as a shock to the markets, no matter whether pre-announced or not, would drive the euro higher against the dollar, possibly to $1.50 if this were to happen now, and provoke all sorts of trouble, not least political trouble. It would be an unwise policy action to take now.

 

What about Axel Weber's argument that there we underestimate the inflation pressures? If Weber is right, then obviously this would amount to a good reason to raise interest rates. The ECB has a price stability mandate, and it must fulfil this mandate. Oil and commodity price are no doubt a problem, but we should not assume that the only forecast error we can make is to underestimate the price rises. Oil has most recently fallen again, and commodities are volatile. A global economic slowdown could see severe oil and commodity price falls.

 

We actually believe that Weber is concerned most about wage pressures building up in Germany, and that he wants to send a strong signal to wage negotiators. A good example is the 30% plus wage demand by the train drivers, but there are wage pressures arising in many other sectors of the economy. After years of wage moderation, during which Germany improved its competitive position vis-a-vis other European countries, the country is now re-entering a more normal period of earnings growth. Nothing dramatic is on the cards, but next next year's wage round could produce more worker-friendly wage settlement than in previous years, and this is something the central bank wants to keep a check on.

 

This is how we interpret Weber's statement. We do not believe that he has any special insights into inflationary processes that the rest of us do not have. For all these reasons we think it is unlikely that a rate rise is on the cards, despite the fact that two senior central bankers appeared to have signalled that it might happen.

Eurointelligence ECB Watch

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