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Marsh on Monday
March 7, 2011, 12:01 a.m. EST
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Europe's rate hike tied to picking Draghi
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By David Marsh, MarketWatch
LONDON (MarketWatch) "” It's happening quicker than I thought. Last Thursday's stronger-than-expected statement on inflation from Jean-Claude Trichet, the European Central Bank president, paves the way for Europe to start monetary tightening next month, compared with the timing of May or June that I predicted last week. Read my column from Feb. 28.
Yet my forecast last week was well ahead of the earlier market consensus view that the ECB would wait until the summer before starting to return to a semblance of monetary normalcy. What has happened to speed everything up?
A series of factors are combining to produce a new environment for monetary rate-setting. Occupancy of the 23-person ECB governing council's key seats "” now held by Trichet and Bundesbank President Axel Weber "” is due to change in coming months. Trichet will be replaced in November by an as-yet-unknown successor, with odds shortening that it will be Mario Draghi from the Banca d'Italia.
Prospects for sterling look grim. The economy looks vulnerable, the Bank of England doesn't care about inflation and the political resolve for austerity is bound to weaken. Foreigners have already started selling gilts. The pound will follow.
Weber will be succeeded at the end of next month by Jens Weidmann, Chancellor Angela Merkel's economic adviser. Getting an unpopular interest rate move out of the way before the new chiefs arrive may be a sage decision, to avoid piling up pressure on freshly anointed incumbents.
And Weber, who is quitting the Bundesbank and the ECB leadership race because his hawkish views are out of kilter with many others within and beyond the ECB, could have special reasons for stamping his imprint on the ECB's policies before he moves on.
The increase in the projected euro-area inflation rate to well beyond the 2% limit that Trichet has been so proud to maintain in the euro's first 12 years is the single biggest direct factor behind the ECB's signal. Higher growth in Germany than in the rest of monetary union is making the Germans not wildly happy but unconscionably nervous. But there is also another strongly political element behind the momentum now building toward monetary tightening.
The prospective improvements in Europe's policy governance will fall well short of the wishes of either the ECB itself or the German government. The much-trumped "pact for competitiveness" put forward by Merkel and French President Nicolas Sarkozy has been watered down almost out of existence by the blunt refusal of most member states to have European decision-making intruding into their own budgetary or labor market instruments.
Merkel is on the ropes after last week's resignation of one of her coalition's best-performing and most popular members, Defense Minister Karl-Theodor zu Guttenberg, who quit after he was proven to have copied large parts of his 2006 doctoral thesis.
She is expecting further political pressure once it becomes obvious that Germany will have to bow to the wishes of indebted states and provide further guarantees for extended euro rescue packages later this summer.
The ECB's move back to a more normal monetary policy provides the chancellor with the minimum amount of cover to avoid a complete meltdown of support for the euro amid fiscally conservative Germans.
At a time of grave disparities in the European economy, the prospective ECB interest-rate increase shows that the euro area is dancing to the tune set by the creditor economies and not the debtor states.
That is arguably the way it should be, but it will certainly lead to unpopularity, above all in Trichet's French homeland. The last ECB rate increase, in August 2008, was a decision of which Trichet is still inordinately proud "” even though (or perhaps because) it sparked a strong outburst of protest from Sarkozy.
Similar indignation from across the Seine can be expected this time round if the ECB goes ahead with an increase rise next month. Merkel and Trichet can, however, be expected to brush such complaints aside. With a bluntness that is rapidly becoming a trademark, Merkel told an audience at the Cebit electronics fair this past week that Germany had to match up to the best in the world, not just to its European neighbors, and that, "Europe on average is not competitive in the world economy."
By pushing the ECB toward an earlier-than-anticipated interest-rate increase, Germany is underlining that it believes the rules of the euro area should increasingly be set with one country in mind: Germany. That may be both a sensible and an ineluctable policy, but these are not the rules of the game that many euro members expected to play when they signed up for the project.
David Marsh is co-chairman of the Official Monetary and Financial Institutions Forum.
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