FYI | Jun 18 2008
By Greg Peel
Lat night the annualised UK consumer price index was announced to have reached 3.3%, up from 3.0% in just a month. This is the highest level since comparable records began being kept in 1997 and well above the Bank of England’s 2.0% comfort zone limit. But instead of rallying on the possibility of a forthcoming rate hike, the pound actually fell against the US dollar.
Before the global credit crisis began, the UK cash rate was 5.5%. The US rate was 5.25% and the European rate 4%. Australia – which had been dealing with long term economic strength – had a cash rate of 6.25%. In contrast to Australia, the US economy was only moderate at best while the UK and European economies were more or less coming out of the doldrums.
A year later the US Federal Reserve has cut its cash rate six times to 2%. The Bank of England has cut twice to 5%. The European Central Bank has remained fixed at 4% and Australia has seen four rate rises to 7.25%. One year ago the oil price was US$70/bbl and it is now almost twice that. Of the four regions, Australia’s is the only one to not see its banking sector decimated by the credit crunch, although there have been some notable casualties. At the same time, as an exporter of commodities Australia has seen its economic growth hold up well. This means the Reserve Bank of Australia has been able to fight inflation by rasing its cash rate. The RBA desperately wants to slow the Australian economy.
The credit crisis had its roots in the US housing market, and the collapse of that market has ushered a sharp slowdown in the US economy, perhaps a recession. As the US economy is by far the largest in the world, under normal circumstances one would expect global inflation pressures to ease as a result. However, with China and other developing nations now in the mix, this is seemingly not the case. The Fed was quick to respond to the credit crisis by slashing its cash rate, concentrating solely on preventing a collapse of the US banking system and a collapse of the US economy. The US dollar has collapsed as a result, which has made it hard to continue assuming inflation would look after itself. The falling dollar has helped to push up the oil price.
The UK has also been a victim of the credit crisis, most notably in the collapse of Northern Rock. While initially choosing to hold the cash rate steady so as not to be seen to “bail out” greedy investment banks, the BoE was forced to capitulate and make, ultimately, two cuts. But while Europe has also suffered a similar fate in its banking sector, the ECB has held fast at 4%, all the time arguing the risk of increasing inflation.
The ECB has been proven correct, and has now made assertions to suggest that a rate hike in July is well and truly on the cards. However, how much of the ECB’s stoicism is actually part of the problem? By not cutting its rate along with its counterparts across the Channel and the Atlantic, the ECB has ensured the demise of the US dollar. As the greenback has fallen, the oil price has risen, encouraging a massive global shift of funds out of traditional bonds and equities and into direct commodity investment. While this is so-called “speculation” – a bet on higher prices – it is also simply an inflation hedge against the diminishing value of the world’s unsecured paper money system.
The whole equation has fed on itself.
It had become apparent to traders in the US over the last couple of weeks that the inflation problem had become so bad that the Fed would now cease cutting to save the US economy and begin hiking to battle the oil crisis. However, this is not the case. The Fed is not likely to cut its rate further and exacerbate inflation but nor is it about to hike either. Bernanke has indicated his concern over the impact a high oil price has on the US economy. Indeed, he is more worried about runaway oil prices contracting the global economy than inflating it through a wage-cost spiral, as the Washington Post’s Robert Novak suggests.
At a time when the wrong monetary policy move could have drastic consequences in either direction, an “on hold” strategy probably appears best. But while this might be Bernanke’s view, it is not a view shared by the hawkish Jean-Claude Trichet of the ECB. If Trichet increases the European cash rate by 25 basis points as is currently the belief, the affect of the Fed staying on hold is lost – the US dollar will fall once more, and the price of oil will rise.
The reason the sharp jump in the UK CPI did not invoke a rush to buy sterling was because the BoE is not expected to raise its rate as a result either. The UK is now staring down the barrel of its own housing slump, and hence it is not a time to start raising mortgage costs. If the UK does suffer a housing slump then its economy will weaken and inflation should, in theory, contract. This is exactly the way Bernanke is supposedly playing his cards now as well.
But Trichet is not coming to the party. The European export industry is livid. The German economy in particular – which itself is the third largest in the world (although China has pretty much caught up) had begun to churn along nicely after years of subdued growth, even as the credit crisis hit. But if the euro continues to move higher against the US dollar and other currencies, Europe’s export industry will be shattered. It’s already struggling, which might have been enough to encourage Trichet not to raise, and yet it appears he will.
There is now a building currency crisis in Europe – a crisis that threatens the very existence of the euro.
The last European currency crisis occurred in the early 1990s, following the last great global credit crisis brought about by the Crash of ’87 and the exposure of excessive amounts of corporate debt. At that time similar tensions built across the Atlantic and the result was a European recession. Indeed, the result was a global recession, but then as now the Fed had responded to a banking crisis by slashing its cash rate while the Bundesbank had stood firm. The US dollar plummeted to US$1.35 to the Deutschmark.
Extracting a Deutschmark equivalent from today’s euro arrives at US$1.25. This particular crisis is worse than in 1992, notes the London Daily Telegraph’s Ambrose Evans-Pritchard, as the US dollar has also fallen to lows against the yen, the pound, and the yuan. Morgan Stanley analysts are now warning that pressures are building up within the European Monetary Union.
The problem with the EMU, and the wider trading conglomerate of the European Union, is that the initial well-intended concept of creating a unified and thus more powerful trading bloc is now threatening to unravel. It is a simple case of the disparities between the economic powerhouses such as Germany and France and the vulnerable economies of Italy, Spain, and the states of Eastern Europe. Morgan Stanley is not predicting the break-up of the EMU but suggests something has to give. If Trichet raises the cash rate, another “catastrophic” event could be triggered, the analysts suggest.
Problems arising within the group of EMU nations would not have arisen had the euro not existed, suggests Morgan Stanley. There are extreme current account deficits being run in Spain (10.5% of GDP), Portugal (10.5%) and Greece (14%). In the meantime, Germany has a huge current account surplus of 7.7%. And the imbalances are only getting worse.
European inflation is running at 3.7%, yet in Spain the level is 4.7%. This might serve as a warning to the Bank of England, as Spain is currently undergoing a property price collapse. Credit growth in the emerging Eastern European economies has been roaring along at 40% to 50% a year, and current account deficits have reached 23% in Latvia and 22% in Bulgaria. These are not EMU members, but they do peg their own currencies to the euro. Nor are Hungary or Romania members, but both hold more than 55% of household debt in either euros or Swiss francs.
The bulk of credit growth in Eastern Europe has been provided by banks in EMU member states Austria, Italy and Greece, and by EU member Sweden. If Eastern Europe implodes – and Eastern Europe is suffering the ravages of runaway inflation like every other developing region – then it will take down EMU members with it, leaving the likes of Germany holding the can. What benefit is Germany deriving from the euro?
If the world ever needed a sudden pullback in oil and food prices, the time is now. But as each day goes past, this is failing to happen.