June 6, 2007

The ECB and their interest rates

As widely expected, the European Central Bank (ECB) raised their key short-term interest rate a quarter-point earlier today, from 3.75 percent to 4 percent. The move comes amid stronger euro-zone growth and growing dissent regarding the relationship between monetary policy and money supply growth.

With annualized first quarter economic growth registering 2.4 percent, as compared to just 0.6 percent in the U.S., recent estimates for both euro-zone economic activity and consumer prices continue to be revised upward as forecasts for labor markets show lower unemployment and wage pressures in the months ahead.

Though many analysts see more rate hikes ahead, some placing the short-term rate at 4.5 percent by year-end, the timing of future increases is uncertain.

Keeping the "money" in monetary policy

Unlike their U.S. counterparts at the Federal Reserve, the ECB monitors both consumer price inflation and money supply growth. One look at the relationship between these two (courtesy of Econoday) shows why euro-zone interest rates are rising while the officially reported inflation measure remains comfortably below the 2 percent target threshold.

The U.S. Federal Reserve has long dismissed the importance of money supply growth and went so far as discontinuing the reporting of the M3 monetary aggregate last spring citing the cost savings that would be achieved.

It has been dutifully reconstructed at nowandfutures.com and shows no let up in growth, the green-to-black transition in the chart below indicating where the government reporting stopped and the independent reporting began.

In Europe, the election of conservative president Nicoloas Sarkozy in France has added to an already growing rift between those who apparently agree with Milton Friedman that "inflation is always and everywhere a monetary phenomenon" and those who would prefer to just "let 'er rip" while monitoring increasingly suspect and controversial government measures of consumer price inflation.

Bloomberg reported on these developments yesterday:

European Central Bank head Jean-Claude Trichet has parried criticism from Nicolas Sarkozy, the new president of his native France. Fresh doubts from Trichet's protege at the French central bank may be harder to ignore.

As the ECB prepares to raise its key interest rate to a six-year high of 4 percent tomorrow, Trichet's faith in the importance of money supply is being questioned by Christian Noyer, 56, who succeeded him as governor of the Bank of France and sits with him on the ECB's governing council.

With Mario Draghi's Bank of Italy lining up with Noyer against Trichet and Bundesbank President Axel Weber, the Frankfurt-based ECB is debating how to interpret money-supply data for the first time since its 1999 birth. The split may make it tougher for Trichet, 64, to forge a consensus over how much further to increase rates.

"The hawks at the ECB give a lot of weight to headline money supply, and that proved useful when they wanted to tighten,'' said James Nixon, an economist at Societe Generale SA and a former forecaster at the ECB. "The Bank of France and others now want to make it slightly harder for the ECB to raise rates.''

Money supply, as measured by M3, has expanded more than the 4.5 percent rate viewed by the ECB as non-inflationary in every month since May 2001. It increased 10.4 percent in April from a year earlier, close to the fastest pace in 24 years. M3 is the broadest gauge of money supply and includes cash in circulation, some forms of savings and money-market holdings.

As the French and Italian central bankers question how much all that new cash has contributed to rising consumer prices while marveling at the economic growth and prosperity that low interest rates have augured in, the memory of hyperinflation in 1923 Weimar Germany is hard for many Europeans to shake, notably Bundesbank President Axel Weber.

That point was reinforced by a May report from the Bank of Italy stressing that money-supply growth may pose "smaller upside risks to price stability'' than thought. It argued that liquidity has been swelled by holdings of assets at financial- services companies such as pension funds. That fans inflation less than money growth, which feeds into household spending and consumer prices, the report said.
For Trichet and Weber, those are fighting words. A May 23 Bundesbank report called money supply an "indispensable element'' in gauging inflation pressures. Weber said in a June 3 speech that monetary statistics still contain "valuable information'' that "help predict future inflation.''

"It would be unwise to discard monetary analysis -- especially now that we find ourselves in a period in which asset prices and liquidity are at a high level,'' Weber said.

As for the Federal Reserve in the U.S., according to the Bloomberg report, Ben Bernanke said last year that "heavy reliance'' on monetary aggregates was "unwise'' and that the Fed has "basically rejected a role for money for the Fed".

It remains to be seen whether the key inflation measure of the Federal Reserve, "core" inflation excluding food and energy with a 40 percent weighting of housing rental costs, will be an adequate guide for charting U.S. monetary policy.