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ECB and Fed: Managing Expectations

Thu, Aug 23 2007, 08:16 GMT
by Joseph Trevisani

FX Solutions

The European Central Bank’s brief is to fight inflation; the American Federal Reserve’s is to attend both inflation and growth. Neither assignment mentions managing the expectations of thousands of money managers, investors and bond and equity traders all of whom are clamoring for a rate cut. But for the next month or so managing those expectations may be the most important role each bank will play. If the central banks manage correctly their will be no surprises on September 6th and 18th, when the banks each meet next, and there will be no dangerous market reaction; if they do not and the markets are surprised or disappointed, they risk reigniting calamity.

The ECB meets September 6th. Until 2 weeks ago a 0.25% rate increase was a foregone conclusion. Bank president Jean Claude Trichet had ostentatiously deployed the rate hike code ‘strong vigilance’ at his impromptu news conference after the last ECB meeting. The ECB would no doubt still like to raise rates, its own inflation projections call for the EMU inflation rate to rise back above the 2.0% target to 2.4% or more by the year end. But market expectations are changing fast and the public pressure to hold the line at 4.00% can only burgeon. The liquidity crunch in the credit markets came to full public attention last Thursday when the ECB added massive funds to the European money markets in an effort to forestall a serious credit squeeze. The question asked by many now is, does it make sense for the ECB to add liquidity one month and raise rates the next? The French Finance Minister Christine Lagarde applauded the Fed cut in the discount rate and wondered why the Europeans didn’t look at a rate cut as well, and she certainly speaks for many in the European business and political community.

Ben Bernanke would probably prefer to keep rates unchanged at 5.25% but he faces a similar dilemma. As of today the markets have priced in a 100% assurance of a rate cut on September 18th. The economy is growing, inflation while reduced is not conquered and to a large degree the commotion in the credit markets is one of confidence and excessive lending restrain not mortgage default. As Richmond Fed President Jeffrey Lacker put it “interest rate policy must be based on the likely path of the real economy not just on financial conditions”. But if that 100% expectation remains intact on September 18th for the 2:15 pm FOMC announcement and a cut is not forthcoming what damage will be done to the calm that the Fed hopes to establish between now and then and will the chairman wish to risk the ensuing violent scenario? If the market wants a rate cut and does not get one then the natural and inevitable reaction will be a reversal of the priced in values. And in the confusion the reaction will quite possibly go too far and risk reigniting many of the recent problems in the credit markets.

Yet there is a further complication. The Fed and ECB themselves may not reach any conclusion about their September actions until very close to the date as they monitor the markets and watch the emergence of new data and information. But the sooner the bankers begin preparing the market for their decisions the better chance they will have of success.

The Fed and the ECB have entered a new era of transparent communication. Both institutions have been at pains to make sure the markets know how and when they are going to act. This policy is quite different from the cryptic communications of the prior era. The new policy is about to be put to the test. In the current situation, with market expectations heavily weighted one way, inherent bank intentions in the opposite direction and no decision made, it will call for all Mr. Trichet’s and Mr. Bernanke's skill to align the markets with their pending September decisions. But that all arrive at the same place at the same time is surely in everyone best interest.

Published on  Thu, Aug 23 2007, 08:18 GMT