Postcards from Old Europe – The rocket that didn’t launch

Trying to divine central bank’s policies by interpreting the public statements made by their representatives always reminds me of the arcane art of Kremlinology. Practitioners of Centralbankology must have been working overtime the past couple of weeks to make sense of the many little tidbits emanating from the bank’s ivory towers. One thing that was evident is that the US and European monetary policy seem to be moving towards each other – the Fed’s comments are getting a little more hawkish, while the ECB’s governors are signaling a possible cut in rates.

Although the ECB has refrained from hiking rates at their meeting on the 1st of April a whole raft of comments before and after the meeting give the impression that an interest rate cut might be in the offing. I don’t want to beat my own drum, but I do have to mention that this was my opinion all along. The simple fact of the matter is that the Eurozone’s recovery is half dead already.

Optimists keep citing the an imminent “export led recovery” as the catalyst for higher growth rates in the Eurozone. This is understandable as the major European countries have usually exported or devalued and the exported their way out of economic weakness. As the devaluation route is now mostly closed, they now have to rely on exports to dig themselves out of their hole. In an interview with the German daily Handelsblatt ECB president Trichet said:

In the normal course of economic activity, recovery most often starts with net exports, then passes over to investment and then, as the third stage of the rocket, so to speak, arrives at consumption.

The only problem is the fact that this doesn’t seem to be working. A look at the ECB’s March report showed that the volume of exports to countries not in the Eurozone actually fell in the last quarter of 2003! This is not something we should be happy to see as it implies that Europe is not able to profit from the rapid pace of US consumption. The rocket is fizzling on the launchpad. While the Asian economies are reaping the benefits of the credit-fueled and consumption driven boom in the US economy the Eurozone has been left standing on the sidelines and has been trying to convince itself that a strong euro doesn’t really matter.

The euro-strength has been helping the consumer by making imports cheaper. The purchasing public responded by increasing the amount of imported goods in their shopping carts all through last year. As it usually takes a while for the effects of a rising currency to fully trickle through into import prices we can probably look forward to European consumers continuing to increase the amount of foreign goods on their shopping list. The only problem with this is that it doesn’t help Eurozone companies one bit.

A rising share of imported goods is doubly negative as consumer confidence is still very low in the Eurozone. The consequence of this double whammy is that the recovery rocket’s third stage is also in danger of malfunctioning. This is in sharp contrast to the US where the third stage of the rocket has firing all through the recession and hasn’t stopped burning yet. The US rocket is burning on fuel supercharged by easy credit and rising asset prices. Some members of the Fed’s mission control team think that this sustained buying spree is harmful and are trying to dampen the perceived speculative excesses by ways of hawkish talk.

A quick glance at the media could support this view, some prices (Gas!) are rising right through the roof! Surely there must be inflation right around the corner? Some people are even suggesting that core CPI is a sham. I don’t think that this is the case. A look at the medium term shows that core CPI and CPI are almost identical. I am assuming that people are looking at price hikes in frequently purchased goods (think gas) and concluding that all prices are rising. This is simply not true. Many goods are falling quite sharply in price – the only problem is that we tend to remember price increases and forget the bargains. Core CPI (and CPI) are low by any standard so I don’t see a rate hike just around the corner.

Back across the Atlantic inflation is low (1.6%) as well which could give the ECB some leeway to cut rates. The only problem that I see, is the fact that a rate cut will not address the root cause of sluggish growth. The relative inflexibility of the major European economies is the major reason why the Eurozone is not able to grow GDP in a meaningful way. Yesterday’s ECB meeting threw cold water on expectations of a quick cut in rates. Could it be possible that the ECB intends to keep monetary policy tight with the aim of “encouraging” Europe’s larger economies to finally speed up their pace of reforms?

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