Trichet May Be Forced to Drop Focus on Inflation (Update2)

By Simon Kennedy and John Fraher


Dec. 20 (Bloomberg) -- European Central Bank President Jean-Claude Trichet, who is trying to stave off both inflation and a credit squeeze at the same time, may soon have to choose sides.

Economists at Deutsche Bank AG, Royal Bank of Scotland Group Plc and Morgan Stanley say Trichet -- who told the European Parliament yesterday that efforts to deliver price stability and encourage banks to lend are ``totally separate'' - - may be forced to follow the Bank of England and the Federal Reserve in cutting interest rates as higher credit costs hurt the broader economy.

``The bank can't have it both ways,'' said Kevin Gaynor, head of economics and interest-rate strategy at RBS in London. ``It can't have temporary support for the market stretching into six months and yet maintain the fig leaf that monetary policy is based on an unchanged view of economic risks.''

Trichet's comments yesterday suggest the ECB's intention is to keep pumping cash into banks, while holding its rate at a six-year high of 4 percent to restrain prices. The Bank of England and the Fed, meanwhile, are saying that credit conditions have deteriorated so much they are already spilling into the real economy and warrant reductions.

``Banks themselves are worried that the impact of their reluctance to lend will lead to a sharper downturn,'' Bank of England Governor Mervyn King told lawmakers in London on Dec. 18. ``That concern is a serious one.''

Cash Spigot

ECB policy makers have kept their benchmark rate unchanged even as the collapse in assets backed by U.S. subprime mortgages makes banks reluctant to lend to each other. The central bank first offered extra cash on Aug. 9, when it lent 95 billion euros ($137 billion) of emergency funds. On Dec. 18, the ECB pumped a record 349 billion euros into the banking system. Trichet said the coming weeks may be ``challenging'' for investors.

``The ECB had a good start in addressing the problems in the money markets, but I think there's a risk of falling behind the curve on monetary policy,'' said Thomas Mayer, chief European economist at Deutsche Bank in London. ``I don't think this is a technical problem confined to the money markets.''

The Bank of England's Monetary Policy Committee this month backed a rate reduction in the first unanimous decision to cut since the Sept. 11, 2001, terrorist attacks, minutes of the Dec. 6 decision showed yesterday. Chairman Ben S. Bernanke and his team at the Fed have lowered their overnight rate three times since September, while the Bank of Canada unexpectedly trimmed its rate on Dec. 4.

Business Confidence

Economic reports this week showed tighter credit conditions are already hurting the euro region's economy. German business confidence declined to the lowest in almost two years in December and the region's manufacturing and service industries grew at the slowest in more than two years.

French growth may slow in the first half of 2008 as tighter credit curbs investment and the euro's appreciation crimps exports, Insee, the country's statistics office, said today.

``The ECB will be forced into a U-turn and the next move in rates will be down,'' said Joachim Fels, co-chief global economist at Morgan Stanley in London.

Trichet and other ECB policy makers nevertheless argue they can't ignore inflation pressures and need to see more signs that economic growth is fading before taking action.

Inflation Risks

Consumer prices rose 3.1 percent in November from a year earlier, the biggest gain since May 2001, as oil and food costs soared, increasing the risk of higher wage demands. The ECB, which has cut rates in the past even when inflation has exceeded its target, expects prices to rise 2.5 percent next year after increasing 2.1 percent in 2007.

``The risks to price stability over the medium term are clearly on the upside,'' Trichet said yesterday.

The People's Bank of China today raised its key interest rate for a sixth time this year to cool decade-high inflation. The Bank of Japan kept its benchmark rate at 0.5 percent as it cut its assessment of the economy for the first time in three years.

The ECB may also be succeeding in bringing down market rates, which would lessen the need for policy action. The cost of borrowing euros fell yesterday. The ECB yesterday auctioned $10 billion as part of a coordinated effort by central banks, including the Fed, to ease markets.

The three-month euro interbank offered rate, or Euribor, dropped 7 basis points yesterday to 4.81 percent, the lowest since Nov. 30, the European Banking Federation said.

No `Magic Bullet'

Gilles Moec, an economist at Bank of America Corp. in London, said Trichet is right to draw a distinction between battling inflation and assisting markets. A rate cut wouldn't serve as a ``magic bullet'' because some banks would still find it hard to raise money, while there is no evidence yet of ``a big contagion from the banking system to the economy,'' he said.

Moec predicts the ECB will raise its benchmark to 4.5 percent by the end of next year.

Still, Gabriel Stein, director of Lombard Street Research, an economic forecasting consultancy in London, said the ECB may jeopardize its economy's expansion and its reputation as the central bank that's coped best with the market crisis.

``The ECB could face a stiff test in early 2008,'' he said. ``If the latest attempts to bring down market rates don't work, the ECB may be running out of policy options.''