Calling the idea that sound fiscal policy undermines growth an example of “very simple reasoning,” European Central Bank head Jean-Claude Trichet has indicated that the ECB could raise interest rates despite the weakened condition of several Eurozone economies.
In a recent interview with The Wall Street Journal, Trichet said, “All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to … be very careful that there are no second-round effects” on domestic prices.
Trichet’s comments have added strength to the EURUSD trade, which has turned in the euro’s favor over the past two weeks on an earlier hawkish comment from Trichet and on the relatively good acceptance of bond offerings from both Portugal and Spain. The euro is up 6% since January 10th.
The ECB’s anti-inflationary bent puts a lot of pressure on the troubled economies of the Eurozone and the austerity budgets that have been adopted in exchange for bailout help. But Trichet’s position is that fighting inflation benefits all, regardless of any fiscal pain the fight might cause.
To be successful, though, Trichet’s threat to raise rates depends on whether or not food and energy inflation is regarded by the people as temporary or permanent. If temporary, then consumer confidence probably won’t suffer much and there will be little demand for higher wages.
If, however, food and energy price rises last longer and appear to be permanent, demands for higher wages will follow, and threatening to raise rates, or even raising them, may not have the desired effect.
The UK faces a similar issue, with inflation in December rising to 3.7%, and some observers saying that 5% is not out of the question, according to the Financial Times. The Bank of England does not believe that the inflationary trend is permanent, and expects the rate to fall later in the year.
Where the ECB is choosing to err on the side of fighting inflation, the Bank of England is choosing to wait and see. In the meantime, both are making gains against the US dollar, and that rise could gather steam in the days and weeks ahead.
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