Firstly let me apologise to anyone who had trouble accessing my blog yesterday. On the day that the news was so significant that I did a later update WordPress came under hacker attack! I hope it works better today as for a while I could not access this blog either. However the news that the European Central Bank is not only considering an interest-rate rise but hinting it will be in April gave plenty of food for thought and will have not only second order implications but third and possibly fourth order ones too.
Why did Mr.Trichet announce this?
I think that if we go back to the December 2nd meeting of the European Central Bank we saw some hyperbole and boasting by Mr.Trichet and I worried about it at the time.
Listening and watching to the Press Conference I have to say I am not sure that the President of the ECB is sending the correct message by crowing about an average inflation rate of 1.97% during its lifetime as today is not the day for that.
He also boasted that German inflation which at this time was only 1.5% was historically low. In my opinion Mr.Trichet was setting his own epitaph as President of the ECB. Sadly for him he picked the moment that inflation shot upwards! We are back to central bankers and timing again,something they are not much good at which should be food for thought as they intervene around the world an ever larger number of times. The latest update from Eurostat is that Euro zone inflation is now running at 2.4% which is above target (the target is just under 2%). So the plan of retiring with inflation nicely on target has gone awry! Hence the human component of the announcement and indeed the rush as Mr.Trichet retires this summer.
Backing this up will be the recent rises in world commodity and now oil prices which will only put upward pressure in the short-term on Europe’s inflation indices…
A contrast with the Bank Of England
If we look again at part of Mr.Trichets written statement we see this which I see as a direct challenge of the policy of the Bank of England and the emphasis is mine.
It is paramount that the rise in HICP inflation does not lead to second-round effects and thereby give rise to broad-based inflationary pressures over the medium term.
As I pointed out in my initial update yesterday It’s not that often that I agree with Mr.Trichet! So let’s enjoy the moment and on a more serious note he is expressing a view which is completely the opposite of the majority of his counterparts at the Bank of England….
Also I would now like to spell out the difference between the two as fortunately we do have an inflation rate in the Euro zone which is directly comparable to the UK one. In January UK Consumer Price Inflation was measured at 4% and in the Euro zone it was measured at 2.3%. We do not yet have February figures for the UK but they will be way above the 2.4% of the initial estimate for the Euro zone. It would appear that the Governing Council of the ECB do not agree that inflationary trends are “temporary” and the result of “one-off” factors and they do not agree this at 2.4% which is much lower than 4%!
Mr.Trichet is worried about inflationary expectations rising whereas the Bank of England keeps assuring us that (from a much higher level of inflation) they are under control! Imagine we come to April and the ECB does raise its official interest-rate to 1.25% in response to inflation at 2.4% whilst the Bank of England does nothing. Accordingly the odds on the Bank of England moving in April tightened considerably yesterday in my view.
Just a thought if this happens are we getting a de facto setting of interest-rates in the UK by the ECB? Makes you think doesn’t it?
What did financial markets make of this?
It would be easy to say that as equity markets surged then this had no impact but to my mind they were acting in response to other influences so we need to look elsewhere. We find the German interest rate market responded quite strongly.
German 2 year government bond yields went from 1.55% to 1.78% (The UK is at 1.45%)
German 5 year government bond yields went from 2.41% to 2.62% (The UK is at 2.56%)
German 10 year government bond yields went from 3.17% to 3.32%
Ouch you might say as in a day this is quite a move which does have implications for the German economy. In effect you could argue that the rate rise was built-in within an hour or two and that the ECB may get its effect from expectations management. Complicated at times isn’t it? I put the UK equivalents in for an intriguing comparison as it is often assumed that German interest-rates are below ours in the UK.
In another move where expectations management might help achieve a policy objective the Euro exchange rate rose too. It rose against the US dollar and is now just below 1.40 against it. This leads me to two main thoughts. Firstly if we look back we saw various occasions where the Euro came under pressure in 2010 which was recorded at the time in the mainstream media as a sign of Euro collapse so does the rally mean it will now survive? I am teasing a little as neither observation is accurate but there is food for thought in a stronger Euro exchange rate when conditions in the periphery have worsened over time. Secondly the rise in the Euro against the US dollar helps to reduce inflation as oil and most commodities are priced in US dollars and so a rise against the dollar reduces prices in your currency.
As an aside I believe in the inflation effect of exchange rates and the Bank of England certainly used to as it has a rule of thumb for comparing exchange rate movements with interest-rate movements. These days quite a few of its publications treat it as an exogenous factor rather than one over which it has some influence.
The impact of this on the weaker European nations
I wrote about the weakest three nations yesterday but there are others that will be affected adversely by this move.
The debate about Spain has been one where her supporters have been quick to declare victory recently. I have found this to be slightly odd because I saw her position as gently deteriorating as even when her ten-year government bond yield headed somewhat lower towards 5% it was still historically high. I use the UK as a benchmark for Spain as it used to be that her bond yields were lower than ours. For example a year ago her benchmark yield was 3.88% whereas the UK’s was 3.98% meaning she was 0.1% lower.Before the ECB’s announcement she was 1.64% higher. Some success!
Just to be clear the issue of yields mostly only affects a country when they issue new debt so higher yields take a while to have a real impact. Specifically they usually have an effect when new more expensive stock replaces older cheaper stock which is maturing, or new debt is issued. Currently that is also a problem as most countries have plenty of new debt to issue and old debt to replace because of the current world financial crisis. This is why countries arrive at a position where they look doomed but often “hang on” for a while with politicians claiming that they have been saved etc….. Like Portugal right now where her Finance Minister is claiming that the average interest-rate on her debt is around 3.5% which sounds ok but ignores the fact that even for one-year debt she has to pay just over 4%.
The real problem for Spain from an increase in interest-rates comes from her troubled housing market as it is my understanding that most of her mortgages are on variable interest-rates and so they will rise if the ECB raises the official interest-rate. For a housing market already in trouble this sounds a rather toxic development to me. Should it weaken further then it will affect her banks and they themselves will be directly weakened by the rate rise as banks around the world have been taking cheap money from central banks and investing it for a profit. I sometimes wonder how much of the apparent improvement in the worlds banking system is due to this and by improvement I mean recorded profits as plainly there has been little or no reform.
In spite of her being the nation most involved in Libya it would appear that at this time Italy is leading something of a charmed life. However I feel that this would be a mistake as sooner or later markets will get around to her. Their strategy remains one a t a time and after Portugal the obvious candidate is her near neighbour Spain. However Italian government bond yields have been rising and the ten-year benchmark is at 4.91%. This puts it some 1.12% above the UK when a year ago it was 0.03% lower.
An attempt to hide the effect on the periphery
As the ECB does not want events to immediately deteriorate in the periphery of the Euro zone should it increase interest-rates in April it has offered an unlimited three-month repo. Put simply you can have now as much money as you want until July 12th at 1%. You can classify this as either good management of a potentially difficult situation or a sneaky effort to avoid an obvious problem! I will let you choose.
If this happens it will be a brave move by the ECB and would clearly indicate a much stronger view on the need to control inflation than that represented by the Bank of England. It is particularly brave because if things deteriorated badly in the periphery it could come under a lot of political pressure to reverse the move which would lead to “order, counter-order, disorder”. By contrast just the announcement of such an intention has reduced the Bank of England’s inflation credibility again.
The London School of Economics
For those who have not followed this story the LSE accepted a substantial sum of money believed to be £1.3 million from Gaddafi’s son. Rather amusingly it is now nicknamed the Libyan School of Economics! I notice that the Director Howard Davies (who has just resigned because of this) is claiming that the its independence is unaffected. I have two questions for readers from this.
1. Does the act of claiming independence mean in effect that you have lost it?
2.If a university accepts money can it do so without compromising itself in some way?
The big event of the day is the US payroll and unemployment numbers and I wish good luck to all those with trading positions over them.