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When It Comes to Rates, Either Fed or ECB Is Wrong

By    |   Friday, 08 April 2011 01:09 PM

In his introductory statement to the news conference after the European Central Bank (ECB) Governing Council decided to increase the key ECB interest rates by 25 basis points, ECB President Jean-Claude Trichet mentioned three times “monitor very closely.”

This should be understood as a code for saying “we will raise our key interest rates again in the near future, but not per se next month and that could be in July, if the upward trend in European inflation ‘expectations’ persists.”

Speaking yesterday in Rome, Cleveland Federal Reserve Bank President Sandra Pianalto, who is not a voter on the Fed's policy-setting Federal Open Market Committee this year and considered a centrist whose views tend to align with those of Fed Chairman Ben Bernanke, said she saw no evidence that sharp rises in food and energy prices would lead to lasting inflation in the U.S., though the Fed is “watching carefully” for any signs of an unanticipated spillover.

Interestingly, she also noted that measures of longer-run inflation expectations remain below 2 percent.

From his side, IMF Chief Dominique Strauss Kahn observed this week that it is the emerging world that faces a brewing inflation problem, not the developed world, hereby making an important point that arguably is at the heart of many of the prevalent trends across financial markets these days.

It now has become clear, at least for the time being, that the Fed and the ECB openly disagree on inflation “expectations” and because of that, investors should take notice that disagreements among central bankers can be dangerous.

We have seen such a situation in 2008, when the ECB promised to raise interest rates just as the Federal Reserve tried to talk up the dollar, which caused at that time a higher dollar while the world had to endure a disastrous melt-up of crude oil prices.

Today, once again, the two most important central banks in the world, the Fed and the ECB, are apparently on different courses. Yes, the Fed isn’t showing any sign of moving its fed-funds rate in the near future while the ECB already increased its benchmark rate by 25 basis points to 1.25 percent, after an unprecedented two-year period remaining at exceptionally low levels.

If I understand Mr. Trichet “code-speaking,” the ECB could be on its way for further rate hikes in the coming months. Interestingly, the ECB contends its rate hike is completely independent of its extraordinary measures to shore up the eurozone.

It’s a fact that no one believes Portugal will not receive the bailout it requested only hours before the ECB raised its benchmark rate. The ECB described its policy still as “accommodative,” which again should be understood as more hikes may be needed, while the ECB also stated it was not “strongly” vigilant that would have meant, we would have seen the next interest rate hike as soon as next month. For now, that’s seemingly not in the ECB cards.

Obviously, the European Union situation is not without dangers. On Thursday, the Bank of England left its bench mark rate unchanged, notwithstanding it is facing a much higher inflation rate because, as it states, actual inflation is driven by uncontrollable higher commodity prices. As we know now, the ECB disagrees, and, of course, one of them must be wrong. The Bank of England aims a single government operating a deflationary fiscal policy. The ECB does not and has now made its point and is arming itself for the future.

For now, we see a strong return of the carry trade and sharp rises of ‘higher yielding’ currencies, the aggressive emerging market rallies and euro strength that is caused, at least in part, by “reserve diversification” of the dollar “hoarders.”

All that said, we see all these movements find their roots in the continued “uncertainty” surrounding the strength of core price (inflation) trends across much of the Western world and the lax monetary policies that these views demand.

No, the story doesn’t end here and we can already identify two areas where stumbling blocks will materialize:

Firstly and logically, ultra-accommodative monetary policies will be subject to review should the perceived balance of risks to price stability shift to the upside.

And secondly, these trends are “contingent” upon risk appetite that is vulnerable to sudden change courtesy of a number of potential catalysts.

This potential for change is the less dynamic of the two and although the plethora of inflation reports highlighted above will be scrutinized closely, the chances are that central banks’ “general” self-assured attitude in the schism between food/energy and core prices will continue to be given the benefit of the doubt as long it doesn’t hit that serious pothole that is out there, and closer than some think.

About the potential for a shift in risk appetite, I’m less sure about a probable timeline. The continued, relentless rise of oil prices that will, at some point “somewhere” in the future, trigger a collective and probably abrupt re-think about the prospects for global growth.

Also extremely important notwithstanding the majority doesn’t seem to think so; the Portuguese request for assistance signals by no means the beginning of the final chapter of eurozone’s debt crisis. Details of this assistance aside, it is clear that the demands upon the eurozone’s periphery in exchange for such funding have already imposed a damaging toll and talk abounds in some political circles that debt default of restructuring for some may yet prove to be the lesser of two evils.

Investors should not overlook what ex-ECB Chief Economist Issing said in an interview to the German magazine Der Spiegel not so long ago: “…It (the euro) certainly doesn't mean that it will be dissolved. It's a good bet that the euro will continue to exist for a long time to come. The question is not whether the euro will survive, but “which” euro will survive. If everyone is liable for everyone else, even in the case of bad policies, it will become more and more difficult for the European Central Bank to defend the stability of the euro…”

In view of the damaging chain reaction “debt restructuring” of one or even more EU periphery sovereign debt would probably unleash, the prevalent sense of calm appears somewhat incongruous, at least that’s what I think about it.

While this may nonetheless persist, it is clear that there is a profound possibility for a marked and sudden change in sentiment, with what all this would entail for a broad number of markets.

As always, we will have to wait and see. For now, I continue to favor gold, oil, the Swiss franc, especially against the euro, the Canadian dollar, the Norwegian and the Swedish kronor.

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In his introductory statement to the news conference after the European Central Bank (ECB) Governing Council decided to increase the key ECB interest rates by 25 basis points, ECB President Jean-Claude Trichet mentioned three times monitor very closely. This should be...
Friday, 08 April 2011 01:09 PM
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