James Saft

In a field of endeavor with a long and glorious history of folly, the European Central Bank is preparing to commit an error for the ages: hike interest rates into the face of a crisis of existence for the euro zone.

There is an increasing likelihood that when the ECB meets  on April 7 they will respond to surging energy costs and 2.4 percent annual inflation – the highest since 2008 – by raising interest rates, probably by a quarter of a percent.

“Inflation rates … are now durably above the common definition of price stability in the euro zone,” ECB President Jean-Claude Trichet told an audience in Paris on Monday.

This reinforced expectations of a hike he introduced in early March when he dropped the words “strong vigilance” into remarks following the last interest rate-setting meeting, a phrase that served as a one month warning of rate hikes to come during the 2005-2007 rate hike campaign.

Reports that the ECB is preparing a new bail-out lending vehicle for Irish banks, taken as a precursor to a wider effort at bank relief, are being read in markets as further evidence that the ECB is ready to tighten. The reasoning is that, having squared away the banks, and their mutually dependent sovereign guarantors, nothing will stand in the way of an old fashioned bout of inflation scourging.

Here we see the ECB’s conception of itself – as an institution proudly above the political fray and dedicated single-mindedly to price stability – clouding its ability to treat with reality.

“Sure”, you can almost hear ECB types say to themselves, “we’ve accepted some pretty horrendous collateral, and sure, we’ve kept insolvent banks alive through providing massive liquidity, but at heart we are just honest inflation hating bankers, just like our forebears at the Bundesbank.”

Actually though, as Bank of England Monetary Policy Committee member Adam Posen points out, the Bundesbank, when confronted with the oil shock and global recession of 1979-80 dealt with energy-driven inflation quite differently.

“The Bundesbank made public that it would take several years to bring inflation back to its target long-run inflation level, even though it would partially offset the shock immediately and inflation would rise. In fact, it took six years for German inflation to be brought back to 2.0 percent, and both the Deutsche Mark and the Bundesbank retained their counter-inflationary credibility,” Posen said in a February speech.

Now, when you recall that the Bundesbank was slightly to the right of Atilla the Hun in its attitude towards inflation, the ECB’s current course of action looks even more, to be polite, remarkable.

GREECE,  IRELAND, PORTUGAL

Remarkable, especially, when you consider what is being asked of the peripheral euro zone countries. Greece, for example, last year tightened fiscal policy by 8.0 percent of GDP, a statistic that is more impressive before you learn that its economy, partly as a result, shrank by 5.0 percent. You really cannot do that too many years in a row, either mathematically, or politically.

A semi-revolt against austerity measures in Portugal prompted the resignation of Prime Minister Jose Socrates last week, leaving a European rescue plan in limbo. Portugal is now being pressured to accept a bailout, but there is real doubt as to whether it will sign on for the measures expected, and even more doubt as to whether it can stick with them over time.

Inflation is not the problem in Portugal, it is declining standards of living, exacerbated by rising energy costs, but really the result of a squeeze on labor and consumption that is its only means of regaining competitiveness as it has no currency of its own to devalue.

Or take Ireland, which is fighting for better bailout terms, its latest gambit being to push the idea of burden sharing for bank creditors to its crippled banking system. As burden sharing means banking crisis, you can take this as a negotiating position. Or consider Spain, whose own banking system and economy will not be helped by the ECB fighting inflation.

Meanwhile there is a lack of convincing evidence even in the stronger countries of the euro zone that inflation is hardening into large wage rises.

In the meantime, there is evidence that the European recovery, uneven as it is, is facing headwinds. Measured in real terms, currency in circulation and overnight bank deposits in the euro zone are contracting, a strong leading indicator of a slowdown. While this trend started in the weak periphery, it has spread to the core, and is troubling.

A rate hike will rain down even more pain on struggling Spain and its peers and will on the margins make their task of outgrowing their debts and honoring their European commitments even less feasible and will do exactly nothing about the real cause of inflation – rising energy prices.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Poor Mervyn King — damned if he doesn’t raise interest rates, futile if he does.

The Bank of England governor is in the unenviable position of having to steer interest rate policy during a period when living standards are being battered, his inflation target is being mocked by even small boys in the street and there is no obvious course of policy which can reconcile the two problems.

The BOE on Wednesday released its quarterly inflation report which judged the chances to be about equal of inflation being above or below its 2 percent target in two years’ time, this despite predicting that it will spike above its current 4 percent rate in the near term.

You might think that presiding over inflation double your target would merit raising rates immediately from all-time lows, but you would, the Governor hastened to imply, be wrong.

“We’re not in the business of futile gestures, we’re in the business of trying to make a dispassionate analysis of the balance of risks to inflation in the medium term,” King told reporters.

Futile is probably just about right, and perhaps a little generous. British inflation has spiked because of global energy and food prices, which will not respond to BOE policy, and because of a rise in consumer taxes which will not be repeated.

At the same time wage growth in Britain is extremely subdued, about 1.8 percent, the economy still has a massive amount of unused capacity and is embarking on a plan of public spending cuts which will throw many out of work and hit government suppliers hard.

The chances of British workers being able to convert rises in inflation into a spiral of wage and further price rises is pretty small at this point.

On top of this, the UK faces two risks, which because they have been around a while get less attention than they should: a weak banking system and a vulnerable property market.

The BOE’s inflation report points out some uncomfortable facts for the banking system: Commercial property, which accounts for about half of loans outstanding, has slid 35 percent in price and many borrowers are in breach of loan terms. Banks have made provisions against some of these loans, but a widespread practice has been to extend terms and wait for a hoped-for recovery in values.

At the same time, the planned removal of government support of banks means between 400 and 500 billion pounds of debt is expiring by the end of 2012, money that will need replacing or will mean a drastic and probably disastrous shrinking in balance sheets.

SHRINKING STANDARD OF LIVING
At the same time, residential property, which has had a miraculously gentle decline, is looking shaky.

So, despite real divisions on the Monetary Policy Committee and expectations among many economists of a rise in rates this Spring, it is very hard to see. The economy might weather the austerity, but then again it might not. The banks and property market may come out OK, but also might not.

As King was quick to point out, the real problem is that the British economy needs reshaping and must do so while paying huge bills racked up by lousy decisions made before the crisis.

Households “are now suffering a squeeze on real living standards for which the current rate of inflation is the obvious symptom but that squeeze on real living standards is going to happen one way or another,” King said.

“It is the price we are all paying for the financial crisis and the subsequent need to rebalance the economy. The only question is, is it better to allow it to happen with a temporary rise in prices or to push down money wages even further …?”

So, no jam today and perhaps no jam tomorrow, an honest assessment if not a popular one.

There is a large danger that the inflation which King says will be “temporary” does not prove to be, a danger that is exacerbated by perceptions that the BOE is reacting to events, perhaps sensibly, but not in strict accordance with their mandate.

My guess is that King is right to allow himself to be damned but to refuse futile acts intended to show his intolerance of inflation.

There may well be a large global bout of inflation, and if there is, Britain will get hurt badly along with the U.S. and most everyone else. If it happens it will be made in Washington, by far more powerful monetary policy, and in Beijing and other emerging markets by demand.

Britain will have to take its lumps and hope for the best.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email: jamessaft@jamessaft.com