What is the ECB smoking?

As the Greatest Financial Crisis Since the Depression (TM) rolls on, complete with continued carnage at the front end of most major yield curves, the divergent views of prominent central banks is coming increasingly into focus. While Fed policy remains extremely easy (as measured by real rates) and the Bank of Canada cut rates yesterday, seemingly not a day goes by without a hawkish comment from an ECB member. Given the apparently universally held view that a) the European banking system is buggered, b) that stuff like Spanish property is in free-fall and requires attention, c) weak sisters like Italy are being crippled by the strength of the euro, and d) as a result, European growth is headed for a massive slowdown, a constant refrain that Macro Man hears from colleagues and counterparties is "what is the ECB smoking?"

Macro Man did a bit of digging to find out. We should recall that the ECB's mandate is to ensure price stability, with the primary definition of this defined as CPI inflation close to, but not exceeding, 2%. Regular readers of this space, or indeed observers of financial markets, will know that the ECB has not achieved this goal in a long time, as demonstrated by the chart below. Now obviously, headline inflation (the object of the 2% target) is being higher by energy prices, and frankly there's not a lot the ECB can do about that in the short term. That having been said, we should recall that the ECB dialed down the rhetoric late last year on the expectation that inflation was experiencing a temporary "hump". Nothing that we've seen so far this year, least of all $119/bbl oil prices, suggests that we're about to coast down the downside of that hump.

More worrying, from the ECB's perspective, is the potential for second-round effects- namely, rising wages that then fed through into broader price rises. In fairness, macroeconomic data on wages has been pretty muted this far. Worryingly, however, core CPI has risen steadily over the past couple of years, and now rests at the ECB's 2% target for headline! If that isn't evidence of incipient second-round effects, Macro Man isn't sure what is.So will second-order effects intensify? One place to look is labour markets to get a gauge of tightness. And there, the message is that European labour markets are very tight indeed. In Germany, the "anchor" or "daddy" of the Eurozone, has seen its unemployment rate fall to the lowest level since immediately after unification.
And what of serial moaners France, who can almost always find something to complain about- be it the level of interest rates or the level of the euro? As one of Macro Man's colleagues observed this morning, the chart below looks like a classic head-and-shoulders formation: a bearish pattern suggesting that the line should head lower. In point of fact, it's a graph of France's unemployment rate, which is at 25 year lows. That bears repeating: French unemployment is at 25 year lows! You can just imagine the memo that Trichet and co. composing a memo to the French Finance Minister. "Dear Mme. Lagarde: Shut the f*** up!"
But enough of the core: what of the periphery? The market is replete with stories of collapsing prices for Spanish coastal properties, which inevitably drag the economy down with it. How valid are these fears? As far as Macro Man can see, not nearly enough to alter the ECB's calculus. Spain's own house price index , recently updated for Q1, has yet to show a quarterly decline this decade. Sure, the price of some coastal properties is falling.....but its hard to see the ECB (whose own Frankfurt homes haven't budged in value over the last few years) having much sympathy for British owners of vacation homes, who in any event are benefiting from the currency move!
And finally, what of Italy, particularly now that Signore Berlusconi, his fake hair, and fake tan are back in charge of Italy's government? It's taken as gospel that Italy is getting squeezed by the strength of the euro, and indeed that Berlusconi will moan about it. On the latter issue, Macro Man has no doubt that Berlusconi will indeed raise a stink. On the former, colour Macro Man unimpressed. The chart below shows the rolling twelve month sum of Italy's trade balance. He cannot help but notice that despite the sharp rise in oil prices over the last couple of years, the trend in Italian trade (supposedly crippled by the euro) has actually improved. Cry me a (Tiber) river, Silvio.

So what are we left with? Prices that are too high and threatening to stick. Historically tight labour markets. Few obvious signs of macroeconomic stress in supposedly vulnerable Club Med countries. Rather than asking what the ECB is smoking, Macro Man can't help but wonder what the market is smoking for thinking the ECB shouldn't hike.