Thursday, July 3, 2008

Trichet Adopts Greenspan Policy as ECB Attacks Prices (Update3)

By Simon Kennedy

July 3 (Bloomberg) -- European Central Bank President Jean- Claude Trichet may be taking a leaf from former Federal Reserve Chairman Alan Greenspan's playbook.

The ECB raised interest rates for the first time in more than a year today to stem inflation even as economic growth slows. Lehman Brothers Holdings Inc. and ING Bank say that in doing so, Trichet is adopting Greenspan's strategy of taking out insurance against events that have little chance of occurring, yet pose high risks if they do.

The ECB's worst-case scenario is that inflation concerns fail to dissipate and become embedded in the 15-nation economy, sparking a wage-price spiral that requires even higher rates later if not quashed now. The cost of ensuring that doesn't happen may be weaker growth.

``The ECB is pursuing a risk-management approach to monetary policy,'' said Martin van Vliet, an economist at ING in Amsterdam. ``They are determined to prevent higher inflation expectations from becoming self-fulfilling. Prevention is better than cure.''

The ECB increased its benchmark rate by a quarter point to 4.25 percent, the highest since 2001. It is the first central bank within the Group of Seven to tighten monetary policy since financial markets seized up last August.

Raising Rates

Other central banks from Russia to Brazil are raising rates as advancing prices replace the global credit crunch as their biggest concern. Indonesia increased borrowing costs today for the third time in as many months and Sweden lifted its benchmark rate to a 12-year high. Iceland kept its key rate at a record 15.5 percent. Merrill Lynch & Co. economists forecast 78 percent of the central banks they monitor will raise rates.

Trichet took economists by surprise last month when he said the ECB may increase rates. Since then, inflation has accelerated to 4 percent -- the fastest in 16 years and double the bank's limit.

As food and oil prices set records, policy makers have said they intend to restrain inflation expectations amid concern workers will demand more pay. Their nightmare is a repeat of the 1970s, when officials accommodated surging energy costs only to have to stomp harder on the economy to control prices later.

The ECB acted ``to prevent second-round effects,'' Trichet said in Frankfurt today. ``It is our strong determination to keep medium- and long-term inflation expectations anchored in line with price stability.''

He damped speculation of more increases in borrowing costs by saying that he has ``no bias'' on further moves.

`An Extra Nudge'

While arguing expectations are still ``well anchored'' in the longer term, Michael Hume, chief European economist at Lehman Brothers, said there's enough motivation for the ECB to risk a sharper economic slowdown by raising rates.

``With inflation risks now rising, policy may need to be used to give it an extra nudge down,'' said Hume. ``Like the Fed, we expect them to succeed in managing risk, but in doing so, it seems likely they will ultimately cause growth to weaken by too much.''

Overshooting is one of the downsides to risk management, which was formulated by Greenspan when he ran the Fed for 18 years. ``A central bank needs to consider not only the most likely future path for the economy, but also the distribution of possible outcomes about that path,'' he said in a 2005 speech.

`Amplify Cycles'

His successor, Ben S. Bernanke, adopted a similar strategy in chopping the Fed's main rate seven times since September in an effort to avoid a recession. The Fed, which unlike the ECB has the task of both controlling inflation and fostering growth, has sometimes paid for insuring against risks.

It cut its benchmark rate to a 45-year low of 1 percent in 2003 to fend off deflation, only to fuel a mortgage boom that turned to bust. Its 1998 bid to counter a credit-market collapse after Russia defaulted was followed by 4.5 percent growth and faster inflation in 1999.

``Risk-management policies are misguided in that they are an attempt to fine tune the economy, yet usually exacerbate problems and amplify cycles,'' said Bob Eisenbeis, former head of research at the AtlantaFed and now chief monetary economist at Cumberland Advisors Inc. in Vineland, New Jersey.

Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York, said the ECB is making that mistake.

`Policy Error'

He estimates 88 percent of the increase in commodity prices isn't translated into broader inflation and blames Trichet for fanning price fears. ``Hiking rates now is a policy error,'' said Weinberg.

Hume predicts the ECB will start cutting rates in January. The economy is already stumbling. Confidence among businesses and households fell to a three-year low in June, retail sales plunged and manufacturing and service industries contracted.

Risk management ``implies plenty of policy flexibility and volatility, both in terms of heading off the risk and removing the insurance once the risk has passed,'' said Hume.

Investors disagree. They've priced in a further rate increase to 4.5 percent by the end of the year and most are betting on another by March, Eonia forward contracts show.

Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt, said the ECB may be happy to pay the price of slower growth to tame inflation. Labor costs rose the most in five years in the first quarter and oil today reached a record of more than $144 a barrel.

``It seems that a severe economic slowdown is not only tolerated, but possibly even needed to anchor inflation expectations,'' Guntermann said.

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