• Concern. The proposition that the US economy is already in recession has attracted a growing number of supporters. But hard data, such as employment or purchasing managers’ indices, do not yet support this view. The really critical aspect is private consumption (pages 3-5).

  • Spending. Consumer sentiment has plummeted to recession levels (cf. chart). The housing slump, negative wealth effects, tighter lending standards and the erosion of purchasing power by high inflation are increasingly crimping private consumption. A shrinking GDP in Q1 2008 is almost inevitable, and the second quarter is on the razor’s edge.

  • Airbag. But even if the US economy were to formally slide into a recession, it will be short-lived and moderate. Massive fiscal and monetary policy stimuli should stabilize the economy in H2 2008.

  • Eurozone. The commodity-driven rise in inflation is increasingly becoming a drag on growth in the eurozone as well. The hoped-for turnaround in consumption is not materializing. This holds especially true for Germany. As a result, EMU-wide growth remains clearly below potential and requires support from the ECB. However, yesterday’s meeting made clear that the ECB will not ease before mid-year (pages 6-9).

  • Further topics:

    – Weekly Comment: Inflation still “needles” the ECB (page 2).

    – France:     Employment growth – not as good as it looks (page 10).

    – Data outlook:     ZEW growth expectations to decline again; US consumer confidence continues to spiral down (page 12).

    – Market outlook: EUR and govies to remain in demand (page 20).


Inflation still "needles" the ECB

Yesterday’s ECB press conference marked a new high moment in the top-level public policy debate on the appropriate response to the crisis, with the ECB emphasizing that keeping inflation expectations well anchored is of paramount importance, in contrast to the Fed arguing that this is the time to exploit the hard-earned inflation credibility to fend off a serious recession. The ECB is not dogmatic, however, and the press conference contained a few pragmatic openings to a more dovish position, as well as explicit recognition of the exceptional features of the current situation, first and foremost the slowdown-defying rise in commodity prices. I still believe the ECB will cut rates in June in response to weaker growth data, but EUR/USD is the most likely near-term casualty, with 1.60 now a plausible target.

Yesterday’s press conference confirmed that the ECB is confident and fully determined to diverge from the Fed’s response to the ongoing crisis, as long as growth data will allow this. Trichet opened his statement stressing strong shortterm upward pressures on inflation and upside risks to medium- term price stability. He emphasized that anchoring medium to long-term inflation expectations is of the highest importance— implicitly distancing the ECB from the Fed, which is flirting with further monetary easing even in the wake of a slight up-drift of inflation expectations. He unveiled new staff forecasts which, based on the market’s rate cut expectations as of mid-February, see inflation still above 2% even in 2009 (2.1% midpoint, down from 2.9% in 2008). While Trichet was careful to say the ECB never underwrites market expectations, the clear implication was that market rate cut hopes are inconsistent with achieving the inflation target.

There were a few but very important pragmatic openings to a more dovish position, however: First, Trichet conceded that rising food and fuel prices would hurt consumption, although he maintained that consumption would remain resilient. Second, he conceded that the recorded strong dynamics of loans to non financial corporates still needed to be explained, as it contradicted the signals from the bank lending survey— although his conclusion was still that the financial crisis did not seem to have impacted significantly the supply of credit to enterprises. Third, he noted that strong monetary growth overstates the true underlying dynamics—although again he insisted that these remain robust. Fourth, he conceded that the forecasted deceleration in growth (to a midpoint of 1.7% in 2008 and 1.8% in 2009) would tend to cool core inflation.

The ECB, therefore, is not dogmatic, it is fully cognizant of the risks, and monitors the situation with great attention. It also recognizes that we are in an extraordinary situation: Trichet emphasized that we are facing unusually high pressure on commodity prices, whereas if it is confirmed that the global economy is slowing down (unless we are all victims of a collective nightmare, that is…) one would normally expect commodity prices to cool off.

In this extraordinary situation, however, the ECB firmly believes that the top priority must be to anchor inflation expectations and prevent these exceptional pressures from commodity prices from triggering second round effects that could lead to a lasting increase in core inflation. It is also confident that the growth outlook remains sufficiently robust to allow it to concentrate fully on anchoring inflation expectations. (Of course Trichet reiterated that “there is only one needle in our compass”, but he did acknowledge that slower growth normally cools off inflation). The ECB’s position is, therefore, the mirror image of that of the Fed: the latter believes inflation expectations are sufficiently anchored that it can focus on its greatest concern, growth; the former believes growth is sufficiently resilient that it can focus on its single mandate, inflation. Trichet noted that central banks around the world are now moving in different directions, some tightening, some easing, some on hold, presumably all of them pursuing price stability under different macro circumstances. The ECB, therefore, is simply responding to a more benign macro outlook in Europe compared to the US.

It seems, however, that we are witnessing a top-level public policy debate on the appropriate response to the crisis, with the Fed arguing that this is the time to exploit the hardearned inflation credibility to fend off a serious recession, and the ECB arguing that the longer-term benefits of wellanchored inflation expectations should not be jeopardized for the sake of short-term growth gains. The ECB believes it holds the high moral ground, and Trichet yesterday recalled with some well-deserved pride the circumstances when the ECB defied consensus to pursue the policy course it believed appropriate, and was proved right by successive events. The magnitude of the gamble that the Fed is taking on inflation is becoming increasingly apparent to the market, and it is therefore hard to dismiss the ECB’s position out of hand.

I believe the ECB is alert and pragmatic, and that by midyear it will respond to weaker-than-expected growth data with a first rate cut. EUR/USD, however, is still the most likely short-term casualty. As Trichet keeps referring us to the official but empty US “strong dollar” rhetoric, 1.60 is now a fully plausible near-term target.