Home > Uncategorized > 2011/04/07: ECB: Psychology Trumps Economic Reality was Confirmed at Press Conference

2011/04/07: ECB: Psychology Trumps Economic Reality was Confirmed at Press Conference

There is little doubt that the ECB 25 basis point base rate hike to 1.25% today was in part to reinforce its pre-eminent inflation Hawk stature. However, it would seem that it was thoroughly justified in spite of concerns in some quarters about the overall necessity for Europe at large, and especially the impact on the weaker sisters at the periphery. As was not only apparent to informed observers but also ultimately explicitly articulated during the Q&A at the press conference, this was at least as much an exercise in controlling the extended inflation psychology has any significant address of actual current price escalation.

There was a very pointed and highly relevant dissent from the need for an ECB hike at this time published yesterday. Not surprisingly, that was from the Editor of the Financial Times. He covered all of the primary points of the nature of the current round inflation and lack of secondary effects to date. All of that is significantly consistent with the position of the Bank of England and the Federal Reserve.

However, we beg to differ on two significant fronts. The first is the ECB’s unique mandate among central banks. Secondly, the degree to which today’s modest hike will actually not make much difference to the fortunes of the weak sisters at the periphery of Europe is fairly apparent to anyone who has fully considered the issue. 

You can either read our highlighted version for the portions we felt were most critical, or review the original editorial at www.ft.com. [As usual, we encourage anyone who has not already set up a profile to access the excellent content at FT.com to do so posthaste.]

[Our response to the points in the well-thought yet ultimately misguided FT editorial are best covered in the order they were published. The subsequent review of interesting questions and responses at the press conference will be structured to best summarize the overall thrust of ECB psychology, and some of the same specific issues raised in the FT editorial.]

The FT Editor readily acknowledges that the 2.6% inflation is indeed uncomfortable. Yet he is all too willing to rely upon the fact that it will not “…keep growing forever”, and rely upon the idea that “…the risks of second-round inflationary effects are low.” Yet, bond markets are already beginning to reflect fears of those second-round effects. And as one who has seen this unfold previous during the 1970s, second-round effects remain significantly subdued right up to the point where they are not.

In other words, once labor feels that the cost of living has not only risen but will continue to do so, the degree of labor militancy which is possible typically far exceeds central bankers expectations. And that would be especially so for Germany, where strong economy and skilled labor force might combine to create the worst forms of those dreaded second-round effects. Of course, the same can be said of the other, stronger economies in Europe core.

The Financial Times editorial warns “Choking the recovery would block the best way out of the sovereign debt crisis…” and that “…the ECB must beware of bias towards the German economy.” The latter of which is obviously meant to mean not overreacting to its strength. However, we’re not really sure what the implication of rates moving up from as low as 1.00% to 1.25% is really going to do to those peripheral borrowers who are already paying a significant premium to German interest rates. As most of that borrowing is based upon the longer dated instruments from two years and beyond, an ECB tightening which encourages confidence to return to the recently beleaguered German Bund and shorter-term instruments is more likely to marginally lower the cost of funding for the periphery.

As a final point regarding the editorial, it notes that the ECB has done more than any other entity to prevent the collapse of the weak sisters at the periphery of Europe. Yet, that has been accomplished “…by propping up both sovereigns and banks. It is understandably desirous to retire from this role, which it thankfully took on when those better placed to address the crisis failed to act.”


That last bit is the most telling observation, and is consistent with the ECB’s extreme disappointment on the failure of European political class (which is to say especially Germany) to act on bolstering the funding and functions of either the European Financial Stability Facility (EFSF) for the future successor European Stability Mechanism (ESM.) There was very specific concern on its part that neither of those entities being allowed to engage in secondary market bond purchases. It seems that at least for now that role will continue to fall to an ECB who would rather not further for its balance sheet with deteriorating peripheral sovereign debt instruments; but is forced to do so. Possibly Monsieur Trichet was sending a message that it will not let this burden which has been left in its bailiwick prevent the ECB from exercising its primary mandate on inflation. Whether or not this focuses the mind of Europe’s political class is yet to be seen.

As to the specifics of the press conference, there were several points key points that were reviewed which were telling in terms of the policy decision and the psychology behind it; and the degree to which it was indeed significantly psychological. The first of those was the very first question which was asked, and answered with the clear response we suspected (as noted in this morning’s analysis): NO, President Trichet would most definitely not confirm this was the beginning of a general tightening cycle; preferring instead to the expected, classical “these are each individual decisions” response.

He also noted there was no particular shift of preeminence in the ECB raising rates prior to the Fed on this cycle. That was dictated by different economic circumstances. However, we can only suspect that the commodity price inflation which caused the ECB to act allowed for some further message in today’s hike that it is not a huge fan of the Fed’s quantitative easing program.

There was also a question regarding whether austerity would really work for weaker, less competitive economies. We (along with many other informed observers) happen to have our own previously expressed questions about that. And as much as everyone knows there might be risks out there that weakness begets weakness in places like Greece and Portugal, Monsieur Trichet push the question aside by saying there was just a need to normalize excessive behavior (i.e. rein in the profligacy.) Only time will tell whether any of that will work out.

And among many other good questions there was the coup de grace. In response to a question from Brian Blackstone of the Wall Street Journal on global inflation not being affected much by the ECB move, so how could they expect a mere 25 basis point hike would head off second-round effects, the ECB President was very explicit: “That depends on us…” And he went on to expound about second round effects being exactly what they are addressing by attempting to affect the ‘psychology’ prior to potential for any pernicious wage spiral, sustained inflation, lower productivity, etc., etc., etc.

So with due respect for the Editor of the Financial Times, it seems that a timely psychological intervention by the ECB was what we actually witnessed today. And having seen how the lax US central bank approach to inflation in the mid-late 1970s allowed for a pernicious situation to develop, we think there was special pressure on the ECB to act where the Federal Reserve and Bank of England feel they cannot, at least with their present weak general economic and (in the case of the US) housing and employment environment.

 Thanks for your interest.

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