Central Banks Clash Over Monetary Policy

Food and energy prices are soaring everywhere. Eurozone inflation is a record 3.7%

Inflation in the eurozone has a climbed to a record level amid higher food and fuel costs, official figures show. The annual rate of inflation in the 15 state zone hit 3.7% in May, according to the Eurostat statistical office.

The figure is the highest since 1996, when Eurostat started using the current methodology for calculating inflation. There are concerns that price growth will keep accelerating, and the European Central Bank warned it will raise interest rates to slow inflation.

The rate of inflation was up from 3.3% in April, and compares with a 1.9% figure in May 2007. Eurostat said that the main driver of inflation last month was an increase in food prices, which were up 6.4%, and transport costs, which were 5.9% higher.

Central Banks Powerless

Home prices sure aren't going up, nor are autos, appliances, home furnishings, or other big ticket items. It is prices of relatively inelastic items (food and energy) that is causing the CPI to go up. And if Trichet thinks he can control food or energy prices by hiking interest rates he is only nuts.

Perhaps hikes are warranted, perhaps not. I firmly believe not, but no one really knows. Central bankers are guessing. They are big time guessing and they have a huge propensity to guess wrong.

Greenspan guessed wrong to bail out banks in the wake of LTCM, guessed wrong about a completely absurd Y2K scare when he poured on liquidity fueling the dotcom bubble, and guessed wrong in Spring of 2000 when he said the risk of inflation was to the upside. A few month later Greenspan overreacted, and eventually guessed wrong again by slashing rates to 1% and holding them too low too long, fueling a housing bubble. Greenspan specifically, and central bankers in general, guess wrong at every critical juncture.

For more on central bank guessing and the ramifications thereof, please see the Fed Uncertainty Principle.

The only solution to this mess is to get rid of central bankers and let the free market set rates. Sadly, we are going the route of expanding the powers of those that created the mess in accordance with Fed Uncertainty Principle corollary number 2.

ECB Fights Federal Reserve

The Telegraph is reporting Morgan Stanley warns of 'catastrophic event' as ECB fights Federal Reserve.

The clash between the European Central Bank and the US Federal Reserve over monetary strategy is causing serious strains in the global financial system and could lead to a replay of Europe's exchange rate crisis in the 1990s, a team of bankers has warned.

"We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe," said a report by Morgan Stanley's European experts.

Just as then, Washington has slashed rates to bail out the banks and prevent an economic hard-landing, while Frankfurt has stuck to its hawkish line - ignoring angry protests from politicians and squeals of pain from Europe's export industry.

Indeed, the ECB has let the de facto interest rate - Euribor - rise by over 100 basis points since the credit crisis began.

Just as then, the dollar has plummeted far enough to cause worldwide alarm. In August 1992 it fell to 1.35 against the Deutsche Mark: this time it has fallen even further to the equivalent of 1.25. It is potentially worse for Europe this time because the yen and yuan have also fallen to near record lows. So has sterling.

"The tensions will not disappear into thin air. They will find fault lines on the periphery of Europe. Painful macro adjustments are likely to take place. Pegs to the euro could be questioned," said the report, written by Eric Chaney, Carlos Caceres, and Pasquale Diana.

The point of maximum stress could occur in coming months if the ECB carries out the threat this month by Jean-Claude Trichet to raise rates. It will be worse yet - for Europe - if the Fed backs away from expected tightening. "This could trigger another 'catastrophic' event," warned Morgan Stanley.

Who's Bluffing?

I think the Fed is bluffing and all Bernanke really wants is to buy time in a strong dollar sing along with Paulson. However, the risk of collapse of the US dollar if the ECB starts hiking is genuine.

Ironically, so is the risk of collapse of the Euro alliance itself.

Support For Euro In Doubt

When Ambrose Evans-Pritchard first suggest the EU might break up I thought he was off his rocker. Not any more. I am not going to put odds on it, but troubles are mounting and rifts are getting wider. It is clearly not out of the question for Italy, Spain, Ireland, and others to want to opt out.

Inquiring minds may wish to consider Support for euro in doubt as Germans reject Latin bloc notes.

Ordinary Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal, raising concerns that public support for monetary union may be waning in the eurozone's anchor country.

Germany's Handelsblatt newspaper says bankers have detected a curious pattern where customers are withdrawing cash directly from branches, screening the notes to determine the origin of issue. They ask for paper from the southern states to be exchanged for German notes.

Each country prints its own notes according to its economic weight, under strict guidelines from the European Central Bank in Frankfurt. The German notes have an "X"' at the start of the serial numbers, showing that they come from the Bundesdruckerei in Berlin.

Italian notes have an "S" from the Instituto Poligrafico in Rome, and Spanish notes have a "V" from the Fabrica Nacional de Moneda in Madrid. The notes are entirely interchangeable and circulate freely through the eurozone and, indeed, beyond.

People clearly suspect that southern notes may lose value in a crisis, or if the eurozone breaks apart. This is what happened in the US in the Jackson era of the 1840s when dollar notes from different regions traded at different values.

A spate of news articles in the German press has begun to highlight the economic rift between the North and South of eurozone.

There is criticism of comments from Italian, Spanish, and French politicians that threaten the independence of the ECB, viewed as sacrosanct in Germany.

But the key concern appears to be price stability. Germany's wholesale inflation rate reached 8.1pc in May, the highest level in 26 years.

The cost of bread, milk and other staples has rocketed, adding to the sense that prices are spiralling out of control. Ordinary people are blaming the new currency - the "Teuro" - a pun on expensive - for their travails in the supermarket, even though the recent spike in farm goods and energy prices has nothing to do with monetary union.

A group of leading German professors warned at the outset of EMU that the euro would tend to be weaker than old Deutsche Mark, and that it would fuel inflation over time. German citizens were never given a vote on the abolition of the D-Mark, which had become a symbol of Germany's rebirth after the war.

Many have kept a stash of D-Marks hidden in mattresses to this day. A recent IPOS poll showed that 59pc of Germany now had serious doubts about the euro.

Breakup Impossible?

It might sound unlikely for a breakup to occur but stop and consider What if Britain joined the euro today?

Would joining the euro be good for Britain?

Needless to say, I disagree. It is worth conducting a `Gedankenexperiment’ as to what would happen if Britain abolished sterling at, say, 12 AM this morning.

Interest rates would be cut instantly from 5pc to 4pc, a great deal lower than the safe limit calculated by the Bank of England. The exchange rate would be frozen at a perverse moment. After trading at around 66 to 68 cents for several years, the sterling-euro rate would jump to nearly 79.30 cents.

This would be a boon for Gordon Brown. He would enjoy a short-term shot in the arm. The housing crash would slow.

He would enjoy a second shot of luxurious stimulus as the euro came down from its overvalued levels against the dollar and Asian currencies over the next two to three years.

But note that direct foreign investment flows into the eurozone have turned massively negative. The euro is being held up by two forces: “hot money” flows that take advantage of the 2pc yield differential over the US (like the hot flows that pushed sterling to silly heights of $2.11 against the dollar and 250 yen before the credit bubble burst);

The effect of all this stimulus would be delicious for a while. It might even be enough to re-elect Gordon Brown if he was clever with the timing. He could blame the onset of galloping inflation on Frankfurt. At first.

Just think what would have happened if Britain had joined EMU at the start. Eurozone interest rates were 2pc until December 2005. Rates anywhere near this level would have caused the UK boom to explode out of control. Brown’s boom-bust debacle would have been even worse.

The UK economy is highly leveraged to the credit and commodity cycle. It is completely different in its structure and rhythms from core Europe. EMU’s one-size-fits-all policy would inevitably cause violent swings from overheating to underheating -- or booms to bust.

One Size Does Not Fit All

The one size policy is wreaking havoc with European stability right now. And it's fitting that the dividing line is North and South, just like the Civil War in the US. International clashes over monetary policy are heating up, and so are clashes within the Eurozone itself. There is plenty of fuel for a fire. All it takes is someone to strike the match.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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