Fed is Steady as We Go, No Rush To Signal Tighter Monetary Policy
In the wake of yesterday’s FOMC meeting, the message was read loud and clear by currency and financial markets that the Fed is holding pat with ultra loose monetary policy and will go through with the full $600 billion alloted for Quantitative Easing 2.
While some Fed watchers may have been anticipating some more optimistic language on the economy, for the most part the Fed provided a “glass is half empty” message. Yes there’s growth and incoming data shows that, but the growth is not enough to bring down unemployment while underlying inflation remains subdued.
ECB Ready to Act Against Inflation
On the other hand, the comments and messages being sent from the ECB are much more hawkish – a result of inflation moving above the 2% target in December. Investors are speculating on the probability that inflationary pressured would cause the European Central Bank to raise rates soon from 1%.
We touched on some of those comments from ECB President Trichet this past Monday and he re-echoed those sentiments in today’s session. The ECB would do “what is necessary” to keep inflation in check, a nod towards the prospect of higher rates.
The main concern for the ECB is that inflationary pressure that is being fed by higher commodity and import prices seeps through to “second round effects” such as workers demanding higher wages in compensation for higher living costs.
From Bloomberg: ECB’s Bini Smaghi Says Imported Inflation Can’t Be Ignored in Euro Region
“European Central Bank Executive Board member Lorenzo Bini Smaghi said policy makers can no longer afford to ignore imported inflation after President Jean- Claude Trichet pledged to do what’s needed to ensure price stability.
“A permanent and repeated increase in the prices of imported products will tend to impact on inflation in the advanced countries, including the euro area,” Bini Smaghi said in a speech in Bologna today. “This phenomenon can no longer be ignored.” The euro jumped more than half a cent to $1.3747 and yields on German two-year government notes rose as investors adjusted expectations for ECB rate increases.
Bini Smaghi’s comments follow Trichet’s pledge in a Bloomberg Television interview in Davos last night to “do what is necessary” to keep prices stable. Import prices in Germany, Europe’s largest economy, jumped an annual 12 percent in December, the most since October 1981, and euro-area inflation breached the ECB’s 2 percent limit for the first time in more than two years.”
For now Trichet and others say that key interest rate are “appropriate” but the gears are turning and the more public comments about action vis-a-via inflation is perking up the EUR against the USD and others.
Diverging Interest Rates
For a long time now we haven’t had to actually price in too much changes in benchmark rates from the key developed nations. As long as the economy was fragile, there didn’t seem to be an impetus for raising rates, and tightening policy. In the US, high levels of unemloyment and low levels of underlying inflation means that there is still no hurry for hte Fed, though bond vigilatess and others may now say that the Fed will be slow to respond to up-ticks in inflation.
We can see that the ECB is taking the issue much more urgently, and if inflation continues to be above the 2% target of the ECB then we could see the ECB take the step to raise rates.
Here’s a good Reuters write up on this topic: FED FOCUS-ECB on inflation alert, Fed unmoved
That would put the two major central banks – the ECB and the FED – on diverging paths in terms of interest rates, with the interest rate differential helping to boost the EUR against the USD.
Will higher rates batter the weaker countries in the Euro-zone, its very possible. But, Trichet and those at the ECB believe that price stability is paramount, and that all the countries of the Euro-zone should want higher rates if it means price stability.
We will have to wait and see how this story plays out and closely watch inflationary pressures in the developed world. We have already witnesses that inflation is posing a very serious conundrum for the UK, which faces annual inflation of 3.7% while the economy contracted 0.5% in the 4th quarter.