Letter From Europe
The Fed and the ECB
BEN Bernanke, the current Fed chairman has recently made several cuts in the Federal Funds rate (from 5.25% to 3%) and it is widely expected that on March 18 he will announce further cuts. But in a recent statement, Jean-Claude Trichet, the president of the European Central Bank ruled out all possibilities of lowering its benchmark interest rate (4%) in the near future. So the question is: Why are the Fed and the ECB pursuing such divergent interest rate policies?
The simple answer to this question is that at this particular moment the immediate objectives of these two central banks are different. While the Fed's immediate objective is to stimulate economic growth, or at least try to stave off a looming recession, the ECB is trying to control inflation, which now stands at 3.3%, which is well above the bank's threshold of 2%.
If the oil and food prices continue to rise at the current pace, they may set off a wage-price spiral that will definitely lead to even higher inflation. Trichet wants to avoid such a situation. He wants to control inflation so that European economy can grow, even though the growth will be at a low rate -- 1.7% for 2008 and 1.8% in 2009.
He is also worried about the huge build-up of total money supply (M3) in the euro-area, which he believes will increase inflationary pressures.
The current economic situation in the US cannot be considered rosy. The pundits are still arguing as to whether it can be described as a crisis or a recession. The US is running huge budget and current account deficits. Its savings rate is unacceptably low, its stock markets are tumbling, the dollar is weakening, unemployment is increasing and the war costs are rising (estimated to be $3 trillion by Professor Stiglitz). Even its inflation rate (4.3%) is higher than that of the euro-area.
Then, of course, its sub-prime mortgage market meltdown has shaken public confidence in its financial system, which is definitely in a crisis. Most analysts agree that it has been "set off by the simultaneous bursting of property and credit bubbles."
The Fed's latest move to solve the liquidity problem of the seemingly solid financial institutions -- which have become too frightened to finance even conservative debt offerings -- by introducing a $200 billion plan to let them borrow ultra-safe treasury money by using some of their riskiest investments as collateral seems to have failed.
On March 13, Carlyle Capital, an affiliate of Carlyle Group, one of the world's largest private equity funds, stated that it had already defaulted on $16.6 billion and that its creditors were planning to liquidate the fund. The same fate awaits other corporations and mortgage companies like Thornton Mortgage etc.
What is happening to the US financial market? As Professor Krugman of Princeton University pointed out recently, the US economy is caught up "in a vicious circle in which banks and other market players are trying to get out of unsafe investments at the same time, causing significant damage to market functioning."
Professor Krugman also mentioned that at present the total US mortgage debt amounts to $11 trillion. It is scary for the world economy to think that this is the size of the market that is in the process of melting down. Can the Fed stop the process?
Bernanke is in a very difficult situation. He is facing increasingly contradictory pressures of slowing growth (economic activity fell for the fourth consecutive month) and rising consumer prices (4.3%), a condition that echoes the stagflation of the 1970s. If price pressures continue to rise, Bernanke may have no other option but to raise interest rates sooner than expected.
Going back to the ECB, although the recent publication of data showing an upward trend in industrial production in the euro-area strengthens Trichet's position not to cut interest rates in the immediate future, this decision has indirectly created other problems. As the Fed has kept cutting interest rates while the ECB has held them steady, the dollar-denominated assets have gradually lost their appeal to the investors. This policy has relentlessly driven the dollar down against the euro.
Oil prices have reached an all-time high -- $110.20 a barrel -- and gold prices have gone over the $1000 an ounce mark because investors and speculators are pouring money into commodities to hedge against inflation and a falling currency. The euro rose above $1.55 against the dollar for the first time in its nine-year history as the investors' confidence in the Fed's ability to revive credit market and bolster a struggling US economy continued to sink. Some analysts think that the dollar may even reach $1.60 per euro by the end of the year.
A strong euro affects the euro-area's export efforts negatively. On March 10, Trichet complained bitterly against these exchange rate fluctuations. He said that excessive, volatile and disorderly movements are undesirable for economic growth because they disrupt business planning. Of course, what Trichet did not mention was that a strong euro also makes it less expensive for the euro-area to import oil and other commodities priced in US dollars, which helps the ECB to curb inflation.
Central bankers may follow different strategies but their ultimate objectives remain the same, which are, of course, steady economic growth, high employment and low inflation. This axiom holds good for both Bernanke and Trichet. It is true that Bernanke's task has become much more complicated by the sub-prime mortgage meltdown, which according to the chairman of the Federal Open Markets Committee, has been caused by "the ideology of deregulation."
The complexity and the magnitude of the problem are such that no one can say how and when it will be resolved. But he hopes that once the low interest rates have nursed the economy out of the malaise, he can raise interest rates to tackle inflation.
Trichet's strategy is different because the circumstances are different in the euro-area. As he said recently: "We are each in our own universe. Europe's universe is marked by moderating but still acceptable economic growth."
But, bearing in mind that Europe's construction industry is slowing down at a significant pace, it is my guess that by the third quarter of 2008, Trichet will be forced to lower interest rates by at least one half percent. I hope that by that time the inflation in the euro-area will have fallen below 3 percent.
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