ECB stands firm on rates

[HenryTo]

Looks like the window for the ECB potentially cutting rates has closed. Does that mean that there will be no Euro carry trade? People certainly were not expecting it - so it may still happen - given that the U.S. Fed has signaled that it will continue to raise the Fed Funds rate.
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ECB stands firm on rates
By Carter Dougherty International Herald Tribune

FRIDAY, JULY 15, 2005

AMSTERDAM Top policy makers at the European Central Bank are standing firm against demands from politicians that it cut interest rates to jump-start the moribund euro-zone economy, citing high oil prices and a burgeoning money supply as two reasons to keep borrowing costs steady.

The option of lowering rates "is not on my mind," an ECB governing council member, Nout Wellink, who is also president of the Dutch central bank, said in an interview Thursday.

During a brief period in June, following the rejection by France and the Netherlands of the European Union's proposed constitution, the ECB appeared to be mulling a cut in its benchmark rate, which has remained at 2 percent for two years. But as the sense of crisis has faded, top ECB officials in the past few days have backed away from such speculation.

Wellink noted that rapid monetary growth - fueled by historically low rates - may be pushing up real estate prices and keeping bond prices low, two signs that rates may be too low to keep inflation under control. "Asset prices are a relevant issue in the context of whether the ECB should further reduce its interest rates," he said.

"What are the benefits? Uncertain, but very limited. What are the costs? Uncertain, but potentially great," Wellink added.

He also stressed that increasingly profitable businesses have funds to invest and consumers, though their mood is dampened in parts of the 12-nation euro zone, have money to spend.

A raft of European politicians, notably the German economy and labor minister, Wolfgang Clement, and Prime Minister Silvio Berlusconi of Italy have pressured the ECB to lower rates in recent months. Economists from key think tanks and the Organization for Economic Cooperation and Development have also chimed in to support lower rates.

But Otmar Issing, the ECB's chief economist, said Wednesday that the outlook for inflation had become "decidedly gloomier" thanks to oil prices that are hovering around $60 per barrel. Though euro-zone inflation hovers near the bank's target of "below, but close to 2 percent," Issing's comments suggested that higher rates, which would help squelch any inflationary pressures, are more likely than lower ones.

The ECB president, Jean-Claude Trichet, after gently hinting last month that central bankers had discussed a rate cut for the first time this year, avoided any mention of this option at a news conference last week. Now, the bank may be headed in the opposite direction.

"Rate cuts have clearly moved off the table, if they were ever on it in the first place," said Allan Saunderson, an economist with Eurozone Advisors, a Frankfurt consultancy. "It was a pretty short window, and it's probably closed."

The issue of excess liquidity has played a strong role in curbing the ECB's appetite for lower rates, Wellink said.

As it has for much of the past two years, the bank's main measure of the money supply in May grew far faster than the bank's informal target of 4.5 percent, jumping 7.3 percent after a slightly smaller gain the previous month.

Most economists believe this cash is flowing into key asset markets. In real estate, house valuations are rising strongly in Spain, parts of France, and remain high in the Netherlands, as low-interest mortgages tempt more buyers, Wellink noted. As money rushes into the bond market, private and government issuers have been able to pay historically low interest rates.

"It is clear that this building up of liquidity can't go on forever," Wellink said.

The Netherlands experienced such a cycle at the end of the 1990s, when rising housing prices brought the country the highest inflation it had experienced in 20 years, an outcome that could be repeated on a much larger scale in parts of the euro zone and the United States, Wellink noted.

"At the end of the day, what you will get is inflation," he said.

Historically low interest rates for mortgages and bonds lie at the core of the ECB's conundrum, Wellink noted. Central banks have built up strong credibility with markets that they will fight future inflation, and ruthless competition from surging Asian economies keeps the prices of many manufactured goods low - two factors that speak in favor of low rates.

But any number of factors - notably higher oil prices - could spoil this outlook by driving up inflation and upsetting the bet that markets have made on low interest rates, economists note.

Though he cautioned that he was "not making any predictions," Wellink stressed that historic lows, whether of interest rates or inflation, are the exception, rather than the rule.

"There's one thing I've learned in 30 years in this business," Wellink said. "Whatever is extremely low or high - I have always seen corrections."