Klaus Baader was one of the professional forecasters who defied conventional wisdom in 2006 and predicted that Trichet would continue raising interest rates, despite mounting political pressure.
He was proven correct then. Now he is going against the grain again, saying that Trichet will not cut rates, i.e., the euro is too cheap at the moment.
Trichet is in an impossibly complex spot right now, particularly after Kosovo’s secession from Serbia. Kosovo has already threatened to disturb a hornet’s nest of secessionist movements throughout Europe, the strongest of which are in Belgium, northern Italy, and Hungarian nationalists in Serbia and Slovakia. The lower interest rates are, the more economic laggards are subsidized at the expense of the wealthy powers, and the weaker secessionist influences are.
Feb. 21 (Bloomberg) — Financial markets have it wrong: Jean-Claude Trichet isn’t about to cut interest rates, according to the Merrill Lynch & Co. economist who defied conventional wisdom by correctly predicting the European Central Bank president’s course two years ago.
Klaus Baader, Merrill’s London-based chief European economist, said he doesn’t expect Trichet to lower borrowing costs this year. His view, shared by economists at Goldman Sachs Group Inc., ABN Amro Holding NV and Morgan Stanley, conflicts with the opinion of most investors and economists that the bank will reduce its key rate from 4 percent.
“The gap between market expectations and the ECB’s thinking is unusually wide,” said Baader, who two years ago bucked the consensus by forecasting accurately that Trichet would keep increasing borrowing costs. “The inflation outlook is too strong for rate cuts.”
Investors increased bets on a cut after Trichet on Feb. 7 withdrew a threat to raise rates and expressed concern that the outlook for growth had deteriorated. The yield on interest-rate contracts maturing in December is at 3.64 percent, down from 4.18 percent at the start of the year.
Baader’s view that the bank will keep rates higher than anticipated amounts to a bet that inflation, currently above the bank’s target, will remain Trichet’s chief concern, and that a U.S. slowdown won’t derail Europe’s economic expansion as it did in 2001.
If he and the other contrarians are right, investors will have to reverse their recent wagers that Trichet will cut rates by selling two-year government bonds or buying the euro.
Europe’s pace of growth halved in the fourth quarter to 0.4 percent, while retail sales and industrial production fell in December. UBS AG predicts the ECB will lower its key rate by a percentage point to 3 percent this year.
“We now have the economic circumstances in place for the ECB to embark upon easing,” said Julian Callow, chief European economist at Barclays Capital, who expects two reductions after starting the year forecasting none.
Erik Nielsen, Goldman Sachs’s chief European economist, disagrees. He said the ECB’s primary mandate is to preserve price stability, so it has no room to follow the Federal Reserve and the Bank of England, even as economic growth weakens. The Fed slashed its main rate by 1.25 percentage points last month, and the Bank of England cut its benchmark by a quarter point Feb. 7 for the second time in three months.
“Inflation and expectations for it are a hurdle for a cut,” Nielsen said. “Inflation is very stubborn” in Europe.
The annual pace of consumer-price increases in the euro region accelerated to a 14-year high of 3.2 percent in January, pushed above the ECB’s 2 percent limit for a fifth month by food and energy costs. Inflation in France, the euro-area’s second largest economy, accelerated in January to the fastest pace in at least 12 years, according to data released today.
Labor unions are demanding higher wages, and companies may compensate by boosting prices. IG Metall, Germany’s biggest union, yesterday won a 5.2 percent raise for steel workers at companies including Dusseldorf-based ThyssenKrupp AG, Germany’s largest steelmaker.
The Brussels-based European Commission today highlighted the ECB’s dilemma by cutting its forecast for growth in the euro-area this year to 1.8 percent from 2.2 percent, while increasing its prediction for inflation to 2.6 percent from 2.1 percent.
History also suggests the ECB probably won’t act soon. While the bank reduced rates in 2001, even when inflation was above its target, inflation expectations, business confidence and money-supply growth were all lower than they are today, said Elga Bartsch, a Morgan Stanley economist. The ECB’s benchmark rate was also higher, at 4.75 percent.
“The data will likely deteriorate in the coming months, but it will need to cover some distance before it resembles 2001,” Bartsch said. She expects the ECB to raise rates next year.
The contrarians acknowledge risks to their forecasts. Data to be released tomorrow will show services and manufacturing industries close to contraction, according to the median estimate of economists surveyed by Bloomberg News.
Still, Baader and Nielsen said the ECB would have to cut its 2008 growth forecast next month to about 1.5 percent from 2 percent for them to rethink their stance.
While Trichet acknowledged on Feb. 7 “unusually high uncertainty” about growth, he also noted “upside” inflation risks. Bundesbank President Axel Weber and ECB Vice President Lucas Papademos have said since then that rate-cut expectations may be misguided.
“Market expectations for cuts are overdone,” said Nick Kounis, an economist at Fortis Bank NV in Amsterdam, who also expects the ECB to keep rates on hold this year. “Trichet was starting to move away from a tightening bias and is no longer set to raise rates, but in no way is he ready to move to an easing bias and cut rates.”
Record-low unemployment and increased spending by German consumers mean economic growth will “remain fairly solid in 2008, and even if it falls somewhat below trend, this won’t prompt ECB rate cuts,” said Dario Perkins, ABN Amro’s senior European economist in London.
Comparisons to 2006
Baader, 45, sees some similarities to 2006. At the start of that year, he predicted the ECB would push its benchmark rate, then 2.25 percent, to 3.5 percent by yearend, at a time when the median forecast among economists surveyed by Bloomberg News was for a smaller increase, to 2.75 percent. In December of that year, just as he predicted, the rate hit 3.5 percent.
This year as in 2006, the ECB will pay more attention than investors realize to its so-called monetary pillar, which uses money-supply growth as an early indicator of inflation, Baader said. On that score, he sees no “concrete evidence” that banks are reducing lending, with loans to the private nonbank sector growing 8.2 percent in November and 7.1 percent in December.
Does that last paragraph sound familiar? This is what I’ve been saying for a while with regards to USD lending …