The Wall Street Journal-20080201-Fed- ECB Differ -- for Now

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Fed, ECB Differ -- for Now

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As the euro nears its historic high against the dollar, it's throwing into sharp relief the different approaches of the U.S. and European central banks in the presence of an uncertain economic outlook.

Ben Bernanke, the chairman of the Federal Reserve, has made a dramatic bid to rejuvenate the U.S. economy by cutting a key interest rate by 1.25 percentage points in less than two weeks. The chief of the European Central Bank, Jean-Claude Trichet, remains focused on the threat from inflation. Mr. Trichet has left the bank's key interest rate unchanged since July.

The divergence in interest rates has helped push the euro close to its record high against the dollar. Lower U.S. interest rates give investors less incentive to hold dollar deposits. Late Thursday in New York, one euro bought $1.4866, not far from the peak of $1.4968 touched in late November.

The big question for investors is whether Europe will begin to share in U.S. economic ills and force Mr. Trichet to alter his course.

That the euro hasn't yet managed to return to its previous high against the dollar suggests that investors believe the 15-nation euro zone, too, may face significant challenges ahead. Investors say the euro might manage to hit a fresh record in coming days -- fetching $1.50, for instance -- but there's little upside left beyond that point.

"There has been a subtle but very fundamental shift in the financial markets" since the start of this year, says David Woo, head of global currency strategy at Barclays Capital in London. The belief that the euro zone will also feel the pain from a U.S. slowdown "has gained the upper hand."

Mr. Woo points to expectations for where three-month interbank interest rates will be 12 months from now. Since the start of January, the predicted rates have dropped for the U.S. -- and for the euro zone have fallen roughly the same amount. In essence, the market is anticipating that the European Central Bank will need to follow the Fed's lead and lower rates.

The dilemma faced by the ECB was on display yesterday, with data pointing to both energetic inflation and slowing growth. Inflation in the countries that share the euro rose unexpectedly to 3.2% last month, the highest since measurements for the bloc began in January 1997.

Economic confidence, meanwhile, slumped last month to its lowest reading since early 2006, far below market expectations. Figures released by the German statistics agency showed that retail sales fell 0.1% in December and dropped 2.2% in 2007 as a whole.

Unlike the Fed, which is responsible both for supporting growth and for controlling inflation, the ECB has a single mandate: keeping euro- zone prices steady. After the Fed's surprise interest-rate cut last week, Mr. Trichet highlighted in testimony to the European Parliament that inflation remains the ECB's prime focus. "Particularly in demanding times of significant market correction and turbulences," he said, "it is the responsibility of the central bank to solidly anchor inflation expectations."

The euro zone's inflation calculus also differs from the one faced by the U.S., because the euro zone's economy is less flexible. That means that even if growth slows, ECB policy makers can't expect euro- zone wages and prices to adjust as quickly. At a news conference last month, Mr. Trichet bemoaned the fact that many public-sector wage contracts across the bloc remain indexed to inflation.

ECB policy makers acknowledge that the global market turmoil and the heightened chance of a U.S. recession have increased the risks to economic growth. Some have come to believe that growth in the bloc this year could fall below its trend rate of around 2%. But they still see the euro-zone economy as fundamentally sound, with unemployment low, corporate profits high and many factories still operating at or near capacity.

Many private-sector economists offer a darker outlook. Christoph Weil, an economist with Commerzbank in Frankfurt, contends that the financial-market turmoil makes a serious euro-zone slowdown "all the more likely," and believes that the ECB will begin trimming its key interest rate in the second quarter. He expects that policy makers could begin publicly shifting their concern from inflation to growth in March, when new forecasts from the central bank's staff are released.

Such concerns have helped limit the dollar's losses against the euro, despite the Fed's recent moves -- which once might have produced a dramatic fall in the dollar. The euro is "still essentially where we were at the start of December," says Simon Derrick, the London-based chief currency strategist for the Bank of New York Mellon. "That I find absolutely remarkable."

Mr. Derrick believes investors may be focused more on the risks to growth than on those posed by inflation. They "may well believe that the ECB is not being reactive enough and the euro is too highly valued," he says

He also notes that the yield difference between European government bonds, such as those of Italy and Germany, are near multiyear highs. That's a barometer for worries about the economy of the euro zone, Mr. Derrick says, because it reflects differing degrees of confidence in the relative ability of member countries to weather the effects of a strong currency.

Mr. Woo of Barclays adds that the euro is being buffeted by two forces. On the one hand, growth in the euro zone may slow in concert with the U.S., something that limits the currency's strength. But if the U.S. has persistent inflation along with low interest rates, investors could have little incentive to hold the dollar.