Trichet Hikes, Two More Expected; Bank of England Holds; Fundamental Factors Affecting Currencies; Is Trichet's Move the Right Move?

For the first time in 40 years, the European benchmark rate has risen before the US. ECB president Jean-Claude Trichet is concerned about wage growth fueling inflation.

There may be reasons to hike, but wage growth is not one of them. For starters, the only place wages are likely to rise is Germany. Secondly, the idea that wage growth causes inflation is potty.

After months of denial, Portugal is asking for a bailout. The next step is negotiating the terms.

Like the Fed, the Bank of England is standing pat. BOE Governor Mervyn King has placed recovery ahead of inflation. All of these items have been expected.

ECB Hikes Benchmark Rate to 1.25%, More Hikes Expected

Trichet hiked rates as expected. He had been signaling the move for months. Moreover, Trichet Leaves Door Open to Further Rate Moves.

Inflation risks remain on the upside and the ECB’s monetary policy is still “accommodative,” Trichet said at a press conference in Frankfurt after lifting the benchmark rate by a quarter percentage point to 1.25 percent. While “we did not decide it was the first in a series of interest-rate increases, you know from our own doctrine that we always do what is necessary to deliver price stability over the medium term,” he said.

While bonds erased declines and the euro initially fell after Trichet’s comments as some investors pared bets on rapid rate increases, markets still expect the ECB to raise its benchmark to 1.75 percent by the end of the year, Eonia forward contracts show.

The ECB joins central banks in China, India, Poland and Sweden in raising interest rates even as the Federal Reserve remains reluctant to tighten amid divisions among its policy makers. The Bank of England and the Bank of Japan today left their key rates unchanged at 0.5% and 0.1% respectively.

Today’s ECB increase is the first since July 2008 and also the first time in 40 years that Europe’s benchmark has risen before the U.S. equivalent.

“The ECB is setting rates in relation to Germany,” said Vicky Pryce, managing director of FTI Consulting Inc in London and a former adviser to the U.K. government. “It’s a bold move, but a wrong one,” she said, adding Greece, Ireland, Portugal and possibly Spain “need a rate increase like a hole in the head.”

Is Trichet's Move the Right Move?

There is no doubt Trichet has adopted a "One Size Fits Germany" Policy.

Is that the right move?

The answer to the question depends on whether you look at things from the point of view of Germany or from the point of view of Greece, Ireland, Portugal and Spain.

Moreover, and more importantly, Trichet and the ECB should not be making these decisions in the first place. Interest rates should be set by the free market.

Bear in mind that bureaucrats, not a free market dreamed up the EU currency union without fiscal controls, thereby ensuring "one size does not fit all".

Whatever the ECB does, it is highly likely to screw up one or more European countries. Is this any way to set rates?

Portugal Needs $100-$110 Billion Bailout

After months of denial, soaring interest rates forced Portugal's hand. Portugal’s Socialist prime minister, José Sócrates, bowed to market pressures Wednesday night, requesting a bailout.

The New York Times Reports Next Step for Portugal: Negotiating a Bailout

Portugal’s Socialist prime minister, José Sócrates, bowed to market pressures on Wednesday night and requested a bailout from the European Commission, joining Greece and Ireland.

The rescue call, however, comes amid a leadership vacuum in Portugal that might not even be resolved by a general election on June 5. Mr. Sócrates resigned last month when center-right opposition lawmakers led by the Social Democratic Party rejected his austerity package.

One estimate by a European official put Portugal’s needs at about 75 billion euros ($106.5 billion), but some analysts have suggested that the amount could be as much as 110 billion euros. Last year, Greece secured a rescue package worth 110 billion euros and Ireland 85 billion euros.

But consensus among Portugal’s political leaders will not be easy. While opposition leaders agree that Portugal needs a bailout, policy makers in Lisbon know they will must get all sides to support the austerity measures that will be demanded by the international lenders.

To complicate matters, the negotiations are taking place in the midst of an election campaign that will probably be dominated by the question of who is to blame for Portugal’s predicament. The leader of the main Social Democratic opposition party, Pedro Passos Coelho, supported the decision to seek outside help, but he and Mr. Sócrates are blaming each other for forcing Portugal to seek a bailout in the first place.

If the pattern of previous bailouts is repeated, it could take several weeks for a team of Brussels and perhaps International Monetary Fund officials to discuss the conditions of a bailout with Lisbon, which will ultimately need to be approved by European finance ministers.

Bank of England Holds Rates

Bloomberg reports Bank of England Holds Rate, Putting Recovery Before Inflation

The Monetary Policy Committee, led by Governor Mervyn King, set the key rate at 0.5 percent for a 26th month, as forecast by all 57 economists in a Bloomberg News survey. It also left its bond-purchase program at 200 billion pounds ($327 billion), as predicted by all 32 economists in a separate poll.

U.K. gross domestic product rose 0.7 percent in the first quarter after a 0.5 percent drop in the previous three months, the National Institute of Economic and Social Research estimated yesterday. The group, whose clients include the Bank of England and the U.K. Treasury, said underlying growth remains “weak.”

The British Chambers of Commerce this week said first- quarter growth was probably between 0.6 percent and 0.7 percent. It said this is weaker than expected and adds to the argument that the Bank of England should delay raising its key interest rate, which has been at 0.5 percent since March 2009.

At the Bank of England’s March meeting, Andrew Sentance called for a 50 basis-point increase, while Martin Weale and Spencer Dale voted for a 25-basis-point move. Adam Posen maintained his call to expand stimulus with more bond purchases. The minutes of today’s meeting will be published on April 20.

Investors have priced in a 25 basis-point jump in the rate by July, according to forward rates on the sterling overnight interbank average, or Sonia, compiled by Tullett Prebon Plc.

“The MPC is in a very cautious mood, but it will have been a very close call,” Joost Beaumont, an economist at ABN Amro Bank NV in Amsterdam, said before the announcement. “I still hold on to the view they will hike in May. Data have been relatively upbeat recently.”

Mute Market Reaction

All of today's actions were expected.

Currencies are essentially flat across the board but the Euro is down slightly.

Fundamental Factors Affecting Currencies

• Should the ECB not hike twice more as expected, or should the sovereign debt crisis renew with concerns about Spain, expect the Euro to weaken. I believe a sovereign debt crisis led by Spain and Ireland will resurface. Timing is unknown.


• Should the Bank of England delay rate hikes past May, expect the British Pound to weaken.


• Expect the Yen to weaken if Japan does not pass tax hikes to raise money to pay for earthquake, tsunami, and nuclear damage.


• Expect the Australian dollar to weaken if the Reserve Bank of Australia cuts rates. I do expect rate cuts as the Australian housing bust picks up steam.


• Should Republicans manage to cut the US deficit or the Fed to signal a change in stance, expect the dollar to strengthen.


• A Bernanke signal for QE III would certainly be dollar bearish and very bullish for gold. Terminating QE policies would likely be dollar bullish.
  

Finally, sentiment, is amazingly bearish towards the US dollar (I believe unjustifiably so). Extreme sentiment is seldom rewarded, but once again timing is unknown.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List