Trichet Backs Inflation Hawks, Risking Weaker Growth (Update1)

By Simon Kennedy


June 30 (Bloomberg) -- For all his talk of consensus, European Central Bank President Jean-Claude Trichet is having to acknowledge he can't please all of the people all of the time.

A rare public division on his 21-member governing council is forcing Trichet to take sides, backing those who want to raise interest rates this week to curb inflation. Doing so may open an ever bigger rift by easing price pressures in Germany, Europe's biggest economy, at the expense of weaker neighbors.

``I don't remember such an explicit split at the ECB,'' says Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London. ``By lifting rates, the ECB will take unprecedented risks with growth.''

Expansion in the 15-nation euro area is already deteriorating as costlier fuel, food and credit undermine household and company spending, and a strong euro and slowing global demand sap exports. As rates rise, the pain will be spread unevenly. The economies of Germany and France are holding up, while Portugal's is contracting, and growth in Ireland and Spain may be the slowest in 15 years.

``Monetary policy could exacerbate this divergence if the ECB begins a sizable rate-hike cycle,'' says Laurent Bilke, an economist at Lehman Brothers Holdings Inc. in London who previously worked at the ECB.

Quarter-Point Increase

Trichet surprised investors and economists on June 5 when he said there was ``no unanimous'' agreement among members of his council on whether to raise rates and signaled a bias toward an increase with talk of ``heightened alertness'' on inflation. Before then, not one economist out of 32 surveyed by Bloomberg News had predicted higher rates this year.

``Frankly, we didn't quite believe our ears when we listened to Trichet,'' says Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London. All but two of 58 economists surveyed this month forecast the ECB on July 3 will boost its main rate a quarter point to 4.25 percent, the first increase in a year and the highest since 2001.

Forcing the ECB's hand is inflation that surged to 4 percent in June from a year earlier, the fastest in 16 years and in breach of the bank's target of just below 2 percent for a 10th month. A European Commission poll of 30,170 citizens last week showed rising prices overtaking unemployment as their main concern.

Crippling Blow

``The ECB is facing elevated inflation risks,'' says David Mackie, chief European economist at JPMorgan Chase & Co. in London. ``The idea that a 4 percent rate is enough doesn't seem convincing.''

The risk for Trichet is that a strike against inflation now delivers a crippling blow to the euro zone's more fragile economies. Reports last week showed manufacturing and services industries in the region unexpectedly shrank in June, confidence among consumers and businesses fell more than economists forecast and retail sales plunged. The outlook so concerns Marc Touati, chief economist at Global Equities in Paris, that he has launched an online petition against higher rates at http://www.stoptrichet.com.

A widening continental divide is the price of a ``one-size- fits-all'' monetary policy, says Nick Kounis, an economist at Fortis Bank NV in Amsterdam. ``The ECB is not that interested as it sets policy for the region and for inflation -- not growth,'' he says.

`Painful Adjustments'

Eric Chaney, chief European economist at Morgan Stanley in London, says the region faces its biggest test since 1992, when a system of pegging currencies to the deutsche mark collapsed as stumbling economies forced some countries to devalue.

The Economic and Monetary Union that followed in 1999 is in no such danger, Chaney says. Still, ``painful adjustments are likely to take place'' in the form of slumping demand and plummeting real-estate values in economies such as Spain's that became overextended, he says.

Other vulnerable economies include Italy and Greece, as well as Portugal and Ireland. After bingeing on borrowing and real-estate booms as interest rates fell to a four-decade low of 2 percent, most of these nations would be hamstrung by increased borrowing costs and a higher euro.

Private debt totals 175 percent of gross domestic product in Ireland, compared with 97 percent in the euro area, according to Merrill Lynch & Co. Spain is more susceptible to shifts in short-term borrowing costs, with 90 percent of the country's mortgages carrying variable interest rates.

Hangover

Competitiveness has also suffered as labor costs jumped and current-account deficits ballooned, with the deficit for Greece now close to 14 percent of GDP.

The hangover may now be hitting. Portugal's economy shrank in the first quarter. Ireland's Economic and Social Research Institute said last week the country will fall into a recession this year, the first since 1983. Economists surveyed by Bloomberg News see a 45 percent chance Spain will suffer the same fate before the end of 2009.

Meanwhile, Germany's economy is showing resilience after companies cut costs and its government reined in its budget deficit. Germany's growth was the fastest in 12 years during the first quarter, and its current account is in surplus. That leaves consumer prices as the chief worry after they rose 3.4 percent in June from a year ago. So far, the economies of France, Austria, Belgium and the Netherlands are also weathering the global slowdown and credit crisis better than their neighbors on Europe's periphery.

`Considerable' Risks

The differences in the euro area are reflected within Trichet's governing council. Axel Weber, a former academic and president of Germany's traditionally hawkish Bundesbank, led the charge for a rate increase and says inflation risks remain ``considerable.''

Spain's Miguel Angel Fernandez Ordonez has expressed concern about ``contractionary trends'' in his economy, and Lorenzo Bini Smaghi, a member of the ECB executive board, said June 17 that a single quarter-point rate increase ``should be enough.''

Trichet, who speaks today at the Bank for International Settlements meeting in Basel, Switzerland, has typically declared after ECB decisions that they were reached by consensus. Recent comments suggest ``it's going to be very hard for the ECB to come up with a consensus, even after this month,'' says Gilles Moec, London-based senior economist with Bank of America Corp.

Inflation Spreads

For now, Weber and the inflation hawks appear to hold sway as signs accumulate that inflation is spreading beyond commodities such as oil, which reached a record $142.99 a barrel last week.

Ludwigshafen, Germany-based chemical maker BASF SE is raising prices by as much as 20 percent, while employees at Cologne-based airline Deutsche Lufthansa AG want a 9.8 percent wage increase. Inflation expectations, measured by the breakeven on French inflation-indexed bonds, rose to 2.64 percent today from 2.12 percent in March.

``They will do their utmost to ensure inflation doesn't get out of hand,'' says Franz Wenzel, Paris-based deputy director for investment strategy at AXA Investment Managers, which oversees about $831 billion.