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The ECB on the brink of another historic blunder?

ECB rate | The ECB on the brink of another historic blunder? Anthony Harrington

A few weeks before the fall of Lehman Brothers precipitated the most cataclysmic destruction of wealth since the Great Depression, the European Central Bank famously raised its base rate, believing that the economy was overheating and inflation was a problem. It then took the ponderous ECB, with its fixation on price stability, months to grasp that what it should actually be doing under the prevailing circumstances was to cut interest rates to the bone to prevent the EU economy from going into free fall.

In a previous blog we picked up on ECB president Jean-Claude Trichet hinting that a rate cut was on the cards. In a blog for Reuters, Jim Saft argues that when the ECB meets on April 7 it will take fright at surging energy costs and assume that inflation is ramping up. He quotes a comment made by Trichet in Paris recently: “Inflation rates … are now durably above the common definition of price stability in the euro zone.” The use of the word “durably” is clear Trichet code for “inflation is setting in and must be dealt with”. This is what happens when your whole mind set is geared to price stability and you lose track of fundamentals.

What fundamentals? Well, try this. The EU sovereign debt crisis is back in full cry. The Portuguese population threw out austerity and the government that tried to impose it, which leaves Portugal’s debt peddling away downhill like an out of control cyclist heading for a brick wall. The Irish voters are just as adamant that the EU can take its austerity and shove it someplace painful. They want better terms or else. No one seems able to tell them that the “or else” is equivalent to a dive off a high building, i.e. debt everywhere and the bond markets treating Irish bond issuance like a bad joke. Which means no pensions, no payment for public sector workers, plummeting GDP and on and on. In a separate blog I intend to look at the position of the Spanish banks, which recently had their debt downgraded by Moody’s. So not much joy in Spain either. Yet Trichet’s worried about inflation. He should be so lucky.

Which brings us to another fundamental. Oil stocks are currently at a cyclical high so the current high price of oil has nothing to do with supply dynamics directly. It is all about fear, justifiable fear certainly, about Libya, but more importantly, about what the devil is going on between Iran and Saudi Arabia, with Iran stirring up mischief among Bahrain’s majority Shia population and Saudi Arabia’s Sunni rulers giving a helping hand to Bahrain’s Sunni ruling elite to suppress the Shia uprising. If Iran and Saudi Arabia start to come into direct confrontation, even via proxies in Bahrain, all bets are off as to where the oil price might end up. But what, in the name of all the saints, does this have to do with an ECB rate rise? By what fantastical mechanism can a 0.25% hike in the ECB rate bear down on the price of oil and a wobbling Persian Gulf?

What is Trichet thinking of? Is the eurozone rife with wage inflation? Not that we’ve noticed. What it has is food price inflation (largely due to a perfect storm of adverse weather events and surging demand from emerging markets) and energy inflation for reasons already discussed. An ECB rate rise won’t bear on these issues at all. But it will make life that much more difficult for the indebted PIIGS.

Further reading on the ECB rate and the sovereign debt crisis:

Tags: deflation , ECB , inflation , Jean-Claude Trichet , rate cut , rate rise
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