Thursday, December 11, 2008

What is the ECB thinking?

ECB member Axel Weber commented today that the central bank should not reduce rates below 2% given the current inflation rate and target of 2.5%. He suggested that the bank should not cut their benchmark rates so that the short-term real rates turn negative.

The benchmark rate is 2.5% but much of the G10 is moving to zero as the global recessions deepen. Given that the economic news out of the EU is very poor, this ECB view seems completely at odds with with the Fed. Of course, the sole goal of the ECB is to control inflation so it would not make sense to create negative real rates if they wanted to adhere to their goal, but the EU does need more stimulus.

Inflationary expectations are very different in the the EU versus the US. Currently, the US TIPS market is forecasting deflation over the next five years while the EU is showing the inflation protected market at break-evens which are just above 1%.

No wonder the EUR is higher after this announcement. The rate differential may actually get wider between the US and EU. The fact that the ECB is out of step with the Fed will be one of the key monetary themes in early 2009.

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