Eurozone Dilemma

There is an interesting article in the Telegraph by Liam Halligan stipulating The credit crunch could crush the euro. Let's take a look:

The credit crunch is hammering the US, which now faces a likely recession. Things don’t look great for the UK either; here growth could plunge to 1 per cent next year. The reason the eurozone now worries me is the emerging picture of sharply rising consumer prices on the one hand, and falling output on the other. Just like the Bank of England, the European Central Bank will on Thursday try to set monetary policy not only to deal with inflation, but also bolster growth.

Eurozone base rates are likely to be held at 4 per cent – for the sixth month in a row. Most observers think if they do shift this week, the only possible move is up.

That’s because, despite the credit crunch, the ECB’s rhetoric has remained very hawkish. But, in reality, eurozone policy makers now face a classic growth-inflation dilemma – one they share with other Western central banks.

My Comment: The odds of the ECB hiking are remote given the following:

• The ECB is set to pump cash over liquidity concerns.
• French President Nicolas Sarkozy comments about America's drooping dollar as "a precursor to economic war" has talk so heated that some want the EU to intervene in the currency markets. See Currency Twilight Zone for more on this idea.
• The mess with European Interbank Covered Bonds Trading

In light of the above the next move by the EU is way odds on to be lower.
Halligan continues:

The ECB’s predicament is made worse, though, by the euro/dollar exchange rate, and the single currency’s structural flaws. These two unique aspects of the region’s quandary are why its prospects are more gloomy than assumed.

Evidence that eurozone growth is souring is now coming thick and fast. In Germany, the region’s powerhouse, retail sales fell 3.3 per cent between September and October we learnt last week – with consumer spending frail in many other member states too. Europe’s bellwether Economic Sentiment Indicator also fell for the sixth consecutive month.

With weakening global demand slowing industrial growth, the eurozone’s crucial manufacturing sector is starting to suffer as well. The closely-watched IFO index of German business sentiment is well below its December peak. Europe’s PMI industrial index has also dropped close to 50 – a value which, in previous years, has provoked interest rate cuts.

But the ECB will have a big problem lowering rates this Thursday – or anytime soon – because eurozone inflation jumped to 3 per cent in November, up from 2.6 per cent the month before. Inflation has almost doubled since the summer – with rising oil and food costs causing consumer prices to balloon.

My Comment: Once again we have someone confusing prices with inflation. However, central bankers make the same mistake which is one of the reasons we are in the mess we are in. The ECB will not want to cut. Then again, neither does the Fed. In the end they both will.

When inflation surfaces, as it did last week, the markets think the ECB will hike rates – so the euro goes up even more. That then further undermines exports and growth – making it even harder for the bank to raise rates to deal with inflation.

This, in turn, forces the ECB to at least maintain its hawkish rhetoric – certainly compared with the Bank of the England and America’s Federal Reserve – which pushes the euro up anew. This is a conundrum the eurozone can’t seem to escape. And as inflation rises, and the dollar keeps falling, the ECB becomes more and more boxed in.

Something has to give. And it may be that desperate measures are needed.

My Comment: Inflation does not surface in a week unless money supply and credit surfaces in a week. On the other hand, if something has to give then something will give by definition. In this case what is likely to give is a panic move by the Fed to slash rates. It will not help. The UK will join in and the ECB will be forced to join whether it wants to or not.

After all, sceptics like me have always said the operational viability of the single currency won’t be known until the system is tested by a serious downturn. That moment may now come soon.

My Comment: That moment will indeed come soon. The EU will not be immune to a recession in the US and UK as well as a slowdown in China.

Interest rate spreads between government bonds in France, Spain, Germany and Italy have lately got wider and wider. In other words, believe it or not, the markets are increasingly betting on the eurozone breaking up – as political tensions rise, and the needs of inflation-averse nations like Germany can’t be reconciled with much weaker debt-driven members like Ireland and Spain.

Could it happen? Why not? Every other currency union in the history of man has broken up – unless, like the US and UK, it has been preceded by generations of political union, and held together with a federal tax system.

It sounds far-fetched, I know. But the ultimate victim of this sub-prime crisis could be nothing less than the single currency’s existence.

My Comment: I doubt it. The EU has problems but a breakup of the Euro will create more problems than it would solve.

Along with the European Central Bank, the Bank of England will decide on interest rates this Thursday. The "Old Lady", like the ECB, is expected to hold. But, again, there is an outside chance of a December cut. And that chance is steadily growing.

In a telling phrase, Bank of England Governor Mervyn King told MPs on Thursday that a sense of "on-going fragility" now pervades our financial markets. The months ahead, he said ominously, will be "rather uncomfortable".

For many, discomfort is already here - not least because of fears that the housing market is finally turning. Prices dropped 0.8 per cent in November, says the Nationwide, the steepest monthly fall for more than 12 years. Yes - on an annualised basis, property values still grew by almost 7 per cent. But separate Bank of England data also showed that mortgage approvals during October slumped to a 32-month low - with lenders struggling to fund, and reluctant to extend, new loans.

My Comment: Willingness to lend is affected by Northern Rock. Willingness to borrow will be affected by a sentiment change in the UK when borrowers begin to realize housing is not a one way ticket north. That sentiment change is long overdue and when it comes the BOE will have as much luck fighting the housing bust as the Fed. In one word "none". By the way, it appears that sentiment change is finally underway and it's a long way down too.

When buyers' access to credit is hobbled, it is right to ask just where the demand will come from to keep property prices firm. No wonder the latest Telegraph/YouGov poll reports two-thirds of voters now worry about a serious downturn. As the economic outlook worsens, of course, the case for a rate cut grows. The trouble is, as King points out, that with oil and food prices surging, inflation remains a "serious threat".

My Comment: If credit is hobbled and consumers stop spending the idea that inflation remains a serious threat is mistaken. Furthermore, if consumers are indeed genuinely worries about a downturn, they will cause one by not spending. It is a change in sentiment that drives a downturn not a downturn driving sentiment.

In October, CPI inflation jumped from 1.8 to 2.1 per cent - much higher than expected and above the Bank's 2 per cent target. And last week, early evidence emerged that price rises during November hit a 10-year high.

Retailers are now aggressively passing-on input cost rises, according to an authoritative CBI survey. And yet consumers are continuing to spend.

"There is certainly a risk," King told MPs, responding to that survey, "that the MPC won't be able to keep inflation close to target in the wake of further commodity and energy price rises." That doesn't sound like the prelude to an interest rate cut.

My Comment: Which is it? Are consumers genuinely concerned or they just saying so. Retailers can only pass on costs if consumers continue to buy. Non-discretionary items like food and energy are the wrong focus. The right focus was speculation in housing, rising asset prices, etc. Like the Fed, the ECB and the EU ignored those building bubbles. There is a price to pay now and that price is deflation. All this talk if rising inflation is enormously overstated especially if consumers throw in the towel.

King is right to worry. I applaud his hawkish stance. To cut rates when inflation is above target, and rising, smacks of panic. But I have a sneaking suspicion the MPC just might vote for a rate cut this Thursday - even if that means, once again, King himself is outvoted.

My Comment: I applaud the stance for the simple reason rates cuts will not do any good. The entire world is in a credit bubble and it's best to let it pop and for the free market to take care of things. But that is no more likely to happen in the EU or UK and the US.

And as inter-bank rates tighten further this week, and the money markets squeal, more MPC members will jump.

My Comment: Bingo.

Recommended reading for those who think inflation is about prices.

• Inflation: What the heck is it?
• Interview with Paul Kasriel

The current credit crunch should be enough to convince anyone that inflation expectations are overblown. But it's not. I guess that is the way it simply must be.

If everyone saw the threat (like Greenspan did in 2001), they would likely be wrong. Greenspan was ignoring ability and willingness of consumers to spend and ignoring rising asset prices that allowed it. Now that housing is collapsing, jobs are weakening, and consumers spending less, the talk is of rising inflation because of oil prices. That talk is misguided.

Housing bubbles exist in the US, UK, EU, as well as Canada. Those housing bubbles fueled demand for all kinds of goods and services as well as proving enormous numbers of jobs. Now that commercial real estate is slowing there is simply no source of jobs to pick up the slack.

The bubble in the US has popped and evidence is picking up that other countries will soon be following suit. When that happens and the ECB starts cutting, talk of the Euro becoming THE reserve currency will be exposed for the nonsense that it is. Nonetheless, the end of the US dollar hegemony is now in sight. How that ultimately plays out is not today's concern, but I doubt it leads to a complete breakup of the EU.

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