CLOUDS DARKEN ECB´S SUNNY NORTHERN SKIES / THE FINANCIAL TIMES GLOBAL INSIGHT ( VERY HIGHLY RECOMMENDED READING )

Clouds darken ECB’s sunny northern skies

By Ralph Atkins in Frankfurt

Published: May 4 2011 17:52

May is surely one of the best months to plan to be in Helsinki. Bright Nordic spring sunshine would certainly fit with the cautious optimism of the European Central Bank, whose governing council gathers in Finland’s capital Thursday – one of two meetings a year outside its Frankfurt home.


Despite the eurozone debt crisis – on Wednesday, Portugal became its third member to accept an international bail-out – economic growth across the 17-country bloc this year has surpassed the ECB’s expectations.


Last month, the bank reacted to a surge in inflation by raising its main interest rate by a quarter point to 1.25 per cent. The talk in Helsinki will be about the timing of the next increase. Jean-Claude Trichet, the ECB president, could signal a June increase – although July may be a safer bet.


The rest of the world might conclude that the ECB is blind to the possible storms ahead.


Most ominous is the risk of a debt restructuring by Greece, where economic reform plans agreed a year ago have lost momentum. ECB policymakers have themselves given warning of potentially catastrophic consequences – largely because they want to scare others off the idea. Jürgen Stark, an executive board member, has said the 2008 Lehman collapse would be put “in the shade”.


The strength of the eurozone recovery is also uncertain. Growth figures due out next week may show the zone’s economy expanded by as much as 0.8 per cent in the first quarter of 2011 – a sprightly pace that would compare favourably with recent US performance. Yet much of the story is explained by Germany’s export-orientated economy, which may have expanded by more than 1 per cent.


Finland’s economy is also performing strongly, as are Germany’s neighbours, such as France and Belgium. The farther you travel south, however, the gloomier is the news.


Spanish growth is weak, at best, while the pace of expansion across the eurozone seems insufficient to cut jobless queues. More than a fifth of Spain’s labour force is out of work; eurozone unemployment was stuck at 9.9 per cent in March, compared with 8.8 per cent in the US.


Economic prospects could take a turn for the worse. High oil prices, inflation and Middle East unrest almost certainly explain a second consecutive monthly fall in April in the European Commission’s eurozone “economic sentiment” indicator. The surging euro – which has risen more than 5 per cent on a trade-weighted basis since the start of the year – could blight exporters’ prospects.


Even Germany is not acting according to the script. The ECB sees economic growth driven by exports and investment spending feeding through into stronger domestic demand. But it is not clear that is happening. German wage growth remains modest and still bears the scars of the 2009 slump. Weak German high street spending largely explains an unexpectedly sharp 1 per cent fall in eurozone retail sales in March.


Still, the ECB has judged the eurozone recovery robust enough to withstand higher official borrowing costs. It worries that higher inflation linked to oil and commodity prices could become entrenched via “second-round” effects on wages and other costs. There is disappointment that other central banks appear not to share its alarm. The US Federal Reserve has encouraged markets to look beyond temporary price effects; the ECB felt a strong signal was required.


But some ECB council members – including Jens Weidmann, Germany’s new Bundesbank president – go further and argue for a return to a “normal” monetary policy. Decoded, that means interest rates should rise towards pre-crisis levels, even if there is no immediate inflation threat. According to this school, the risk otherwise is of sowing the seeds of future crises. Looking at historic trends, economists reckon a “neutral” interest rate that neither boosts nor constrains growth could be 3 per cent or higher. Unsurprisingly, therefore, financial markets expect a series of ECB rate hikes this year.


Strikingly, however, the “normalisation” argument has not yet been used by Mr Trichet. One obvious objection is that, in the post-crisis world, it is unclear what is “normal”. Cautious instincts could yet prevail at the ECB. But the bank does not always get things right: weather forecasters expect cloudy skies over Helsinki on Thursday.
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Copyright The Financial Times Limited 2011