Hawkish ECB dashes hopes for cutting interest rates

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, March 6, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/06/bcnecb...

The European Central Bank has dashed hopes for an interest rate cut in coming months, defying mounting calls from across the political and economic spectrum for monetary stimulus to head off a sharp slowdown.

Jean-Claude Trichet, the ECB's president, brushed off warnings that the soaring euro would lead to a wave of job losses in European industry, insisting that the top priority of the bank is to prevent food and energy inflation spilling over into wage demands.

"The economic fundamentals are sound. We emphasize that maintaining price stability over the medium term is our prime objective," he said

Mr Trichet offered no hint of lower rates in coming months despite the darkening economic picture and the unprecendented signs of stress in the euro-zone's Latin bloc, where spreads on government bonds in Italy, Spain, Greece, and Portugal have surged to record levels.

There was liquidation of derivatives contracts after Mr Trichet said the ECB would not "underwrite" expectations for rate cuts priced into the future markets.

Italy is teetering on the edge of recession after growth contracted in the fourth quarter, while Spain's property boom is rapidly turning to bust.

Business confidence has sunk across the southern tier of the eurozone, reaching a 20-year low in France.

Mr Trichet's hard-line comments instantly propelled the euro to an all-time high of $1.5372 against the dollar, even though the bank has downgraded its growth forecast to 1.7 percent this year.

A growing number of private economists have accused the bank of underestimating the threat of contagion from the US. Societe Generale has slashed its outlook to 1.1 percent, while BNP Paribas expects 1.3 percent growth.

Europe's labour confederation said the ECB had lost sight of economic reality. "The euro's rise is becoming alarming. It's time for the ECB to recognize at last that the balance of risks are out of kilter and that the threats to growth are now so serious that it is becoming urgent to cut rates."

In rare concord, the employers' lobby BusinessEurope echoed the complaints. "We said when the euro was above $1.40 that we feel the pain. When the euro is above $1.50, it is alarming," it said.

Mr Trichet repeatedly underscored that the ECB was operating in its own sphere and would navigate a very different course from the US Federal Reserve.

The language had echoes of the Bundesbank dispute with Washington in October 1987. The Reagan administration blamed the Black Monday crash on the refusal of the Europeans to ease monetary policy at a time when the dollar was in freefall.

"Financial confidence is so fragile right now, the last thing we need is an internecine fight between central banks. It could get sticky," said Mark Ostwald, and economist at Insinger de Beaufort.

In France, President Nicolas Sarkozy has issued ever-blunter warnings that EU politicians may take matters into own hands if the euro continues to rise.

Under EU treaty law they have the power to set exchange rate policy, which ultimately gives them the whip-hand over the bank.

IMF president Dominique Strauss-Kahn appeared to encourage this radical approach this week, calling the euro overvalued and urging emergency fiscal stiumlus to cushion the downturn.

"The euro's problem is that European Central Bank is overly powerful. There is no political counterweight in the form of a real European finance minister in charge of growth," he told Le Monde.

"If the subprime crisis and the potential difficulties of the American insurers contaminates the real economy even more seriously, every country in the world is going to pay the price," he said.

Peter Bofinger, a top adviser to the German government, called on the ECB to intervene directly in the exchange markets, warning that the euro has already reached levels that are inflicting lasting damage on European industry. "Currency intervention to stop a further rise of the euro would not endanger price stability and is perfectly do-able," he said.

The euro is now above the equivalent levels of the D-mark, franc, and lira in the early 1990s that set off a crisis in the old Exchange Rate Mechanism.

The ECB has held rates steady at 4 percent throughout the credit crunch, even though 3-month Euribor used for mortgages and financial contracts has risen 40 basis points.

For now the bank is more concerned about the latest spike in eurozone inflation to 3.2 percent, the highest since the launch of EMU.

The difficulty for Mr Trichet is that Europe's sclerotic markets mean that slowing growth will not bring down inflation as fast as expected in the highly-flexible Anglo-Saxon economies.

The bank forecasts that inflation will remain stuck at 2.9 percent this year, and linger stubbornly above the 2 percent target 2009. Stagflation is a bigger threat for Europe than it is for the US.

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