Trichet: Forever In the shadow of the Bundesbank

Trichet- A moment of weakness or of insight? Last week in a moment of weakness - or was it insight? - amid a torrent of weak economic reports ECB president Jean-Claude Trichet admitted that the economy was getting much weaker in Europe. Has he really changed his mind? Is the ECB on the brink of a real policy switch?

ECB- a single mandate: Unlike the Fed, the ECB has one policy objective and that is to contain inflation. To pursue that objective the ECB has imposed a ceiling on the rate of inflation, its HICP headline measure. Since that rate has fallen sharply and is now well below its ceiling, many think that the ECB is on its way to aggressive rate cuts. Indeed, even Germany is offering up a second stimulus plan for its economy. There is reason to believe that concerns are shifting over to growth and away from inflation. But are those with such concerns at the decision-making posts of the European Central Bank or not?

Two Views from ECB members...

In a December speech Jurgen Stark, member of the ECB Executive Board, said " After previous substantial rate cuts the remaining room for maneuver is very limited, potentially allowing for small steps only. Having only one instrument at hand the limits of what can be achieved and what cannot be achieved with a single instrument should be recognized. The key ECB interest rate is currently 2.5%. The President of the ECB has made it very clear that the decrease of 175 basis points within two months is exactly what is appropriate taking into account all available information. New relevant information for the euro area which allows for a serious re-assessment of the outlook for price stability will very likely not be available before February or March 2009."

Stark does not sound like he is on board for a much more aggressive policy. But there is more than one voice on policy...

ECB Board member and Vice President Lucas Papademos said in early January, "We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved." Papademos was speaking to reporters on the sidelines of the annual meeting of the American Economics Association in early January 2009. He continued, "Inflation will not be allowed to fall significantly below 2 percent for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis."

Motivations...
Trichet is like any central banker is caught in a cross current of views. But his task is to provide leadership. At the same we must look at Mr Trichet's own motivations.

Trichet's path: Trichet was supposed to be the first head of the European Central bank but he was under scrutiny for wrong-doing at the time the ECB was formed and so the first ECB head was instead Wim Duisenberg, a Dutchman. After Duisenberg left, Trichet, cleared of any wrong-doing, took the helm at the ECB. Trichet had previously headed the Bank of France.

The German legacy: The Germans pressured from the start to locate the ECB in Frankfurt, trying to do what they could to keep the vestiges of tight money and propriety surrounding the euro and EMU monetary policy by maintaining a physical proximity to the Bundesbank. Whoever is the head of the central bank will have the inflation-fighting legacy of the Bundesbank dogging them. Trichet's burden is no different.

The Bundesbank view: With the first two chief economists at the ECB being German, Trichet, and all of the bank, cannot help but feel the imprint of the Bundesbank’s tight-fisted approach from the policy advice being given by the bank's staff. As president he will not want to look like he is less keen on fighting inflation than his German counterparts. Although the economy is weak and inflation is falling fast, Stark already has said the current policy looks ahead and anticipates furthers drops in inflation. His message is not to double count news that was already expected. Looking at the trail of inflation it is clear that the inflation rate in EMU has dropped sharply... but it is also clear that relative to its pre-oil-price spurt trend, improved performance still is not cemented. That longer term climb in inflation's (yr/yr) trend has not been so clearly broken. And it is the focus on the long run has made some of the German commentators reluctant to respond to economic weakness. That may yet stay the hand of Trichet.

The shadow knows: In the wake of rise and fall of Alan Greenspan certainly every central banker will be making policy with an eye to how the future will judge him. If Trichet is taking stock of himself we can expect he will be more affected by the still reluctant view of many Germans. This raises the question of whether Europe will remain behind the curve when it comes to trying to blunt the impact of the financial crisis and recession on the economy. The European fixation on inflation - inherited from the Bundesbank - is not a legacy that is serving Europe well in the episode. Neither is the pressure from this legacy being felt by current ECB president Jean-Claude Trichet a very useful carryover.