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Europe's Beleaguered Central Bankers


When Jean-Claude Trichet took over as president of the European Central Bank last November, most monetary economists predicted the 61-year-old Frenchman would prove a more flexible policymaker, dynamic manager, and skilled communicator than Wim Duisenberg, his gaffe-prone predecessor. Their admiration increased after he effectively talked down the soaring euro in February and March without getting sucked into tortuous discussions about what exchange rate is appropriate. But then Trichet blew it, in many observers' opinion. They blame him for sowing confusion in the markets ahead of a rate-setting meeting on Apr. 1. He is accused of leading the financial world to expect a rate cut that didn't happen.

Now investors worry that the bank can't make up its mind over how to tackle the sluggishness of the euro zone economy. "The ECB seems to be dithering at a time when the economy is in difficulties," says Paul De Grauwe, professor of international economics at the Catholic University of Leuven in Belgium. "You get the impression it is paralyzed."

Trichet isn't the only European central banker whose judgment is being questioned. Ernst Welteke, president of Deutsche Bundesbank, is on paid leave and under pressure to quit after news broke that Dresdner Bank underwrote a stay for him and his family at Berlin's plush Adlon Hotel in 2002. Banca d'Italia President Antonio Fazio has been criticized by Italian Treasury Minister Giulio Tremonti for not doing enough to prevent the scandals that have rocked Parmalat. And the Banque de France, Trichet's old haunt, reported the first operating loss in its more than 200-year history in 2003 due to low interest rates, the strong euro, and restructuring charges.

CONFLICTING MESSAGES

The upshot is that the collective prestige of Europe's once respected central bankers has tanked, prompting calls for greater openness and accountability. "Without guidance from the ECB and with comments by council members difficult to interpret in the run-up to the next council meetings, an increase in the volatility of short-term interest rates in coming months seems likely," warns Thomas Mayer, chief European economist at Deutsche Bank in London.

For Trichet, whose credibility is of the utmost importance, the trouble began a week before the April rate-setting meeting. The normally guarded ECB head hinted in a German newspaper interview that the bank was considering cutting its key 2% interest rate to stimulate weak consumer demand and boost business confidence. "In case our expectations for stronger household consumption and overall domestic demand do not materialize, we will work out our assessment accordingly," he told Handelsblatt. That was enough to convince many seasoned ECB watchers that a rate cut was on the way -- if not in April, then some time in the next two months. Deutsche Bank, Barclays Capital, and Bank of America were just some of the firms that altered their rate forecasts in the days between the interview and the ECB meeting. David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn., says many hedge-fund clients were convinced a cut was imminent. "They turned 180 degrees," he says. "Most had doubted a reduction was likely, but when they heard what Trichet and others were saying both in public and off the record they changed their minds."

Not only did the ECB keep rates unchanged but it more or less ruled out any cut in the near term. "The situation does not call in any respect for a change of our interest rate, and we will see during the next meetings whether or not there is information that will call for any change," Trichet told reporters after the meeting. Market watchers raced to redial their outlooks as some investors scrambled to adjust trading positions in light of Trichet's unexpectedly hawkish tone. The euro, which had been weakening against the dollar, surged 0.3% within hours and the yield on three-month interest-rate futures contracts rose, suggesting the market was downgrading the chance of a near-term cut. "The tone of the press conference [after the ECB meeting] took people by surprise," says Aziz McMahon, a currency strategist at ABN Amro in London. "The markets will treat comments coming out of the ECB with more caution in future."

What unsettles investors isn't so much that the ECB held rates steady. The problem is that Trichet hinted the ECB was going to do one thing and then it did something else.

And outsiders aren't the only ones carping. Trichet is also under fire for failing to communicate effectively with fellow members of the ECB's 18-strong governing council, many of whom didn't believe there was sufficient justification for making a rate cut on Apr. 1. According to economists, the bank, which makes its decisions by consensus and does not publish voting records, is ideologically split. Trichet, by these accounts, is the pragmatist leading one faction, which thinks that the bank should cut rates to stimulate growth if inflation isn't a threat. On the other side is ECB chief economist Otmar Issing, a more "fundamentalist" central banker who thinks the ECB shouldn't step far beyond its mandate of maintaining price stability. Some ECB insiders hint that Trichet personally favored trimming rates by 25 basis points on Apr. 1 and thought he had laid the groundwork for that in the Mar. 24 interview. "There is clearly a disagreement," says De Grauwe, a former Belgian candidate for an ECB executive council seat.

TEUTONIC INTRIGUE

On top of Trichet's faux pas, the euro-zone banking community is also buzzing about allegations that senior officials in the German government leaked the embarrassing details of ECB governing council member Welteke's gratis hotel stay. Critics accuse Finance Minister Hans Eichel of wanting to force him out in favor of someone who would push rate cuts more aggressively. Welteke, a member of Chancellor Gerhard Schr?der's Social Democrat Party, has not lived up to Berlin's expectations since being appointed Bundesbank chief in 1999.

The markets care less about who succeeds Welteke than whether Trichet will continue pushing for a rate cut. Given the sluggishness of the Continental recovery -- the euro zone economy grew at an annualized rate of less than 1% in the first quarter -- he has good reason to argue for one. And speaking after the EU Finance Ministers' meeting in Punchestown, Ireland, on Apr. 6, he stressed that the ECB is flexible. "Are current rates fixed for a considerable period of time? No," he said. The Bundesbank now says it expects a cut at the next rate-setting meeting on May 6. But unless Trichet proves more adept at managing the ECB board and convincing skeptics of his point of view, don't count on that reduction. Thus the puzzlement over ECB policy is likely to continue, which isn't good for either the markets or the euro-zone economy. By David Fairlamb in Frankfurt, with John Rossant in Paris and Maureen Kline in Milan


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