• Trichet. The ECB President could hardly have been any clearer. The tightening cycle will continue! Speculation on an interest rate pause following the generally anticipated rate hike at the beginning of March is now totally off the table. Our key rate target of 4% at mid-year is, therefore, on firm ground. More so, the probability of further tightening in the second half of the year has increased.
  • Concerns. Trichet emphasized his anti-inflation bias and underscored the medium- term focus of monetary policy. The wage negotiations now getting under way and above all the rapid money supply and credit growth pose, in his view, substantial inflation risks.
  • Support. The ECB’s aggressive stance is also experiencing tailwind from the economy. There are growing signs that the widely expected counter-reaction to the strong end of 2006 is less pronounced than originally feared. Hence, real GDP in the eurozone should grow extensively around potential, probably even slightly above.
  • Germany. The advance effects of the VAT increase will see growth in the fourth quarter of 2006 surge to just over 3% annualized. A limited setback at the beginning of this year combined with persistently robust domestic demand are, however, clear upside risks to our rather conservative GDP forecast of 1.1% for 2007.

Further topics:

  • Comment: G7 & Yen - I’m afraid we do have to talk about it.
  • Germany: Structural reforms with no impact on growth.
  • US 2007: No impulses from the inventory cycle .
  • Data outlook: ZEW to recover; US retail sales on a weaker note.
  • Market outlook: ECB supports EUR, bonds remain under pressure.

I’M AFRAID WE DO HAVE TO TALK ABOUT IT …

Finance ministers of the G7 countries are set to meet in Essen, Germany, this weekend. The location is particularly important, because the host, Mr. Peer Steinbrück, may well decide to be less than perfectly gracious, and steer the conversation towards a topic that some guests may prefer to avoid: the Yen, and in particular the EUR-JPY rate.

Not too many people would argue with the view that the yen is currently undervalued. About a couple of years ago, one could reasonably have felt comfortable betting on more upbeat prospects for the Japanese currency. With increasing evidence that the Japanese recovery was entrenched, there seemed to be good reason to expect that the Japanese equity market would outperform, the Bank of Japan (BoJ) would raise interest rates towards a “normal” level, and the currency would benefit from the combination of higher interest rates and stronger inflows.

This scenario has materialized only in part. The stock market did deliver, with the Nikkei putting in a remarkable performance between mid-2005 and mid-2006.

The real economy also confirmed expectations, with growth peaking at 2.7% in 2004 and then settling at a steady and robust 2%. Entrenched growth, however, was not sufficient to convincingly dissipate the ghost of disinflation, the BoJ remained virtually inactive, and the yen confirmed its leading status as favorite funding currency for carry trades. The USDJPY, correspondingly, is still trading above 120, in line with the peak reached in late 2005. And the EUR-JPY started a fairly steady climb in mid-2005, when it traded just above 130, to the current levels just shy of 160.

The US reaction has been relatively cool: Treasury Secretary Paulson stated, matter-of-factly, that the yen is “traded in an open, competitive marketplace.” European policymakers, on the other hand, are more concerned about developments in other open and competitive marketplaces, namely those where the eurozone competes with Japan for the sale of cars, machine tools, and other manufacturing products. Globalization is inevitably eroding the eurozone’s market share in lower-value added products. Germany has been leading the effort to maintain competitiveness in higher value added sectors. But even with a laudable pace of productivity growth, this has also required to keep wages nearly unchanged in real terms - a high price. It is therefore not surprising that the eurozone is increasingly sensitive to any additional obstacle to its competitiveness.

In our view, there is therefore little doubt that the strength of the euro, but in particular the EUR-JPY, will become a more and more charged issue. At the ECB press conference last Thursday, ECB President Trichet had to forcefully reject the idea that the strength of the currency might become a source of pressure on the bank and influence its rate-setting decisions. The ECB is firmly focused on inflation risks; Trichet has announced with the usual “strong vigilance” formula a new rate hike next month, and we believe the bank is set to go all the way to 4%. In this context, they probably see the EUR-JPY mainly as an open window for the political pressure to which they have shut the door.

And they might well be right!

We do not expect anything momentous this weekend. The yen will be discussed, the Europeans will insist on it, but Japan will insist that the currency just reflects the economic fundamentals and the US will remain non-committal. In terms of official statements, expect the usual economics-101 arguments in praise of flexibility and non-abrupt adjustments, and probably some contained expression of European frustrations. But looking further forward, the exchange rate will become a more politically charged issue. We have already flagged the risk that the pressures coming from globalization will trigger protectionist reactions in Europe and possibly the US. As the challenge to improving living standards becomes more and more obvious, European politicians will feel an irresistible temptation to look at the exchange rate as a potential policy tool. After all, this is a division of labor well established in the US: the Fed moves interest rates while the Treasury talks currency.