The European Central Bank (ECB), which is responsible for monetary policy within the 15 member nations of the Eurozone, has made it clear that they are committed to fighting inflation and will not follow the US in cutting interest rates. Jean-Claude Trichet, head of the ECB said “particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility''. Over the past several months the U.S. Federal Reserve has decreased its target overnight rate from its 5.25% high to the current 3.5%. The objective is for lower rates to trickle down into credit markets to encourage borrowing and spending. This helps the economy grow and cancels out the chances of recession; however, such a policy also spreads fears of inflation as increased spending can flood out the money supply.
In the past, Ben Bernanke has attempted to curtail speculation of further rate cuts by stating that recessionary and inflationary concerns are roughly balanced, however the Fed had cut the target rate by a staggering 75 basis points at its last meeting amidst heightened recessionary fears and a record-breaking poor start to a year in the markets. Analysts are also projecting another 25 point or perhaps even a 50 point slash in the rate this month.
The news of the ECB focusing on inflation has scared many investors who believe that a fall in the world’s largest economy will trigger a global recession. Many believe the signs are already present: European and Asian stock indexes have fallen in response to the domestic crisis and euro-region service industries grew this month at the slowest pace in more than four years. However Trichet feels that the larger trouble is inflation as euro-region inflationary rates are currently at 3.1%, well above the ECB’s 2% limit. Meanwhile, potential wage increases across the EU are threatening an increase in that number. Those that believe the ECB is making the right move look to China, where an 11.2% increase in GDP support the possibility of global growth despite a recession in the states.
On the other hand, many investors have dismissed the words of Trichet, and rather believe that the ECB will cut rates in the coming months. Former U.S. Treasury Secretary Lawrence Summers said in an interview “The outlook for Europe is being revised downwards quite rapidly.” And in fact, European bonds rallied on speculation the ECB will be forced to follow the Fed and cut interest rates. Those that feel this way see Trichet’s warning as a mere strategic move to quell inflationary expectations, but that the ECB will cut in a few months, especially given the time lag between U.S. and European economic downturns. But for the time being, the European target rate will stand at 4% and the ECB and Federal Reserve seem to be at odds in economic policy.