ECB May Join Rate-Hike Derby

Global Finance, Sep 2004

EUROPE

A horse race could be emerging between tbe Federal Reserve and the European Central Bank on the interest-rate iront, says John Normand, global fixed-income and foreign exchange strategist at JPMorgan Chase in London.

The dollar's rate disadvantage versus the euro appears set to persist for several months to come, with the Fed maintaining its pace of raising the federal fimds rate by 25 basis points at each meeting of the Federal Open Market Committee, Normand says.

The consensus expects no change in ECU policy this year, based on the view that euro-area growth is too tepid to generate much inflation. According to Normand, however, this view ignores an apparent deterioration in the supply side of the euro-area economy.

"ECB officials have just begun to acknowledge the region s supply-side constraints and may well focus further on them in coming months," Normand says.

A weak supply side, as a result of low productivity gains, implies that the euro area enjoys only limited slack and that even modest growth acceleration would create inflationary pressures. This raises the possibility that the ECB may need to move earlier and more extensively than most investors assume, Normand says.

The possibility of ECB action to boost rates raises the risk that the euro "will continue to enjoy an interest-rate advantage over the dollar until the middle of 2005, as Fed and ECB tightening run concurrently, he says.

Given the fact that the dollar in the past has generally failed to benefit from tightening cycles until and unless LJS short-term interest rates catch up with euro interest rates, any dollar recovery will have to wait until well into 2005, Normand says.