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Trichet Is Confident ECB Can Avert Deflation

In an exclusive interview, President Jean-Claude Trichet defends the European Central Bank’s tough anti-inflation stance.

President Jean-Claude Trichet is defending the European Central Bank’s tough anti-inflation stance, saying the bank’s commitment to price stability enabled it to cut interest rates by 175 basis points in the last three months of 2008 and would help to guard against the risk of deflation in Europe.

Trichet’s comments, in an exclusive interview with Institutional Investor, come as a drop in euro area inflation below the ECB’s target heightened expectations that the central bank’s governing council will cut rates at its next meeting on January 15. The European Union’s statistical agency, Eurostat, said Tuesday that its preliminary estimate for inflation in the euro area fell to 1.6 percent in December from 2.1 percent in November. The ECB’s inflation target is less than but close to 2 percent.

“In the present circumstances it is more than ever important that inflation expectations are solidly anchored,” Trichet told II in a recent interview. “This solid anchoring, to which we are so profoundly attached, is essential to deliver price stability in the medium term and also contributes to protect against the possible threat of deflation, which is not the case at present.”

The ECB raised rates as recently as July 2008 because of surging food and oil prices, a stark contrast to the aggressive rate cuts of the U.S. Federal Reserve Board since September 2007. Even after a 75 basis point cut in December, the ECB’s benchmark refinancing rate stands at 2.50 percent, well above the Fed funds rate of zero to 0.25 percent. Trichet said ECB policy shouldn’t be compared directly with the Fed’s, though, because the European economy is more prone to inflation and has a bigger public sector to cushion recessions. He also said the ECB had been “very bold” in pumping liquidity into the interbank market.

“Ben [Bernanke] and the Open Market Committee, and I and my colleagues in the governing council, have shocks that are not alike,” Trichet said. “And I trust that in these different circumstances we are taking the decisions that are appropriate.”

The ECB president spoke with Institutional Investor ’s International Editor, Tom Buerkle.

Institutional Investor: We’ve seen a significant economic deterioration in the past couple of months. Just how bad are things, in your view?

Jean-Claude Trichet: It’s clear that we have had a significant deterioration of the real economy. The ECB and the national central banks’ staff projections mention a range of zero to minus one percent as the average for growth next year. This is in line with the projections of the major international institutions. What strikes me is that the most recent projections are also the most pessimistic. And this is true at a global level, not particularly at the level of Europe.

Are you concerned that this downward cycle is feeding on itself?

My understanding is that we have to distinguish three different layers. First, we had a long period with an extremely buoyant global economy, with growth that was the most flattering perhaps since World War II. Normally after such a very dynamic episode, there is a slowing down; this is a classical business cycle. On top of that we had this dramatic oil and commodities shock that was partially fostered by the global growth, but took on immense proportions. And then we have a third layer, which is the financial crisis itself and the increase in the tensions that occurred in mid-September. And so, what we have to cope with is the three layers together. They are adding up, which explains the intensity of the global phenomenon that we have before our eyes.

That being said, we have also to take into account the other side of the coin, which is that now we observe the price of oil and commodities going down, and it has exactly the reverse [effect]. When they went up, it was both inflationary and depressive; going down, it is both disinflationary and expansive. It is purchasing power that is given back to the consumer economies. And of course the reaction of central banks and of governments also has to be priced in, because the rapidity with which bold decisions were taken by both central banks and governments is remarkable.

Do you have any misgivings about the ECB’s rate hike in July?

No. Remember, at the time the assessment was that there was a significant threat of stagflation. We had several indications that were signaling a shift upward of inflation expectations, possibly over and above our definition of price stability. And we had several examples of negotiations where social partners were about to create dangerous second-round effects.

As an irreplaceable anchor of stability, the ECB increased rates by 25 basis points to demonstrate that our goal to deliver price stability in the medium run could not be put into question. We regained control of inflation expectations, which was essential. And that permitted us, three months later, in October 2008, to diminish rates when it appeared necessary, taking into account the significant alleviation of the inflationary risks.

Back in August 2007, what persuaded the ECB to act so quickly in intervening in the money markets in the massive way that you did?

Our money market was, for a number of reasons, the first to be heavily touched. In particular on the 8th of August 2007 in New York, several financial institutions had enormous difficulty refinancing their mortgages through their issuance of commercial paper, and that was a signal that led a number of institutions to chase euros in Europe to swap them for dollars.

On the 9th of August 2007, our staff warned the executive board that we were observing a dramatic phenomenon. We had one hour and a half, two hours, of meditation in the executive board, and we took the decision to inject €95 billion for 24 hours at our policy rate. We considered it important to demonstrate to the market that we were the master of our short-term rates. That day we delivered all the liquidity that was demanded, at our policy rate.

You’ve been careful since then to make a clear distinction between liquidity operations and monetary policy. As the crisis has deepened, a lot of economists see that distinction as no longer valid. Do they have a point?

No, I do not think so. This separation principle has served us very well. In the present circumstances it is more important than ever that inflation expectations are solidly anchored. This calls for the monetary policy stance to be always designed precisely to deliver price stability in the medium term, in line with our definition: less than 2 percent, but close to 2 percent. This solid anchoring, to which we are so profoundly attached, is essential to deliver price stability in the medium term and also contributes to protect against the possible threat of deflation, which is not the case at present.

That being said, once we had defined our monetary policy stance and the level of our short-term interest rates, we proved that we could be very bold in our liquidity operations. Today we are supplying liquidity on an unlimited basis for one week, one month, three months and six months.

There was some disappointment in the market that the ECB didn’t go for a full 100-basis-point cut in December. Why did you cut by 75 basis points?

As a matter of fact, the market in its majority was expecting 75; we did 75. It has been one of our most predictable moves. I do not pretend that full predictability is always appropriate, but to be reasonably predictable in times that are so turbulent, so difficult, so demanding is something that might be helpful.

Some Europeans contend that the Fed’s low interest rates in the early part of this decade were at the root of the crisis, and that the ECB, by keeping a medium-term focus and being slower to act, had warded off problems. Would you subscribe to that view?

I am always wary of scapegoating exercises. Some, in the U.S. as well as in Europe, are saying policies in the U.S. were too accommodating over the last years. I do not say that myself. The economy of the U.S. has nothing to do with the economy of the euro area in terms of the shocks that one has to cope with, in terms of flexibility, the size of the public sector and the magnitude of the automatic stabilizers.

Ben [Bernanke] and the Open Market Committee and I and our colleagues in the Governing Council have shocks that are not alike. And I trust that in these different circumstances, we are taking the decisions that are appropriate. What remains true is that, for a number of reasons, the economy of the euro area as a whole is balanced, while the U.S. economy has a significant level of external imbalances, which are part of a complex constellation of global imbalances.

How often do you speak to Ben Bernanke these days?

At certain moments it is very frequent, and rightly so. And I have great confidence in Ben, in his judgment and in the Fed’s judgment. I am happy that such an intimate relationship between central bankers exists in these very difficult times.

There’s an almost universal expectation that the Fed will have to move to quantitative easing in the near future, with rates already close to zero. What’s the possibility that the ECB might have to follow that route?

As I said, we have to cope with different shocks, different economies, different structures, on both sides of the Atlantic. Let me say that what we are doing ourselves today is very appropriate in my view. There is an element I would like to stress particularly: the combination of the unlimited supply of liquidity in euros, of the unlimited supply of liquidity in dollars on our side of the Atlantic with the swap agreement we have with the Fed, and of the enlargement of the eligibility of our collateral, has contributed to augment the size of our balance sheet by 55 percent over the last 12 months. This is substantial.

Axel Weber, the Bundesbank president, was quoted in a recent interview as saying he wouldn’t want to see rates go below 2 percent, while Athanasios Orphanides, the governor of the Central Bank of Cyprus, has raised the possibility of unorthodox policy moves. Is there division within the Governing Council?

As you know I never comment on the statements made by my 20 colleagues of the Governing Council. They all have to explain our policy — and this is very important — in various environments, in various languages and to respond to very different questions. And I know that they are all sticking to the position defined in common for the Eurosystem as a whole: we are a very united Governing Council. That being said, there is only one porte parole of the Governing Council as a whole, and that is the president. This simplifies greatly our communication.

Does something need to be done to complement monetary policy with more coordinated fiscal and regulatory policy in Europe?

We are not a full-fledged federation. We have no federal government, we have no federal budget, and we have to cope with a situation that is obviously complex. But I’m struck by one fact. At the setting up of the euro, there were a large number of observers who were saying, ‘It’s too bold, it won’t function, they put the cart before the horses’ and so forth. Finally, after ten years, one sees that we have a single currency that is credible, that has preserved price stability and has been able to surmount a lot of major exceptional difficulties.

I am also struck by the fact that we had to cope with a large number of problems, including some that could have been of the Lehman Brothers–type. With decisions taken, in particular in Belgium, in Germany, in the Netherlands, in France, in Luxembourg and in other countries, we coped with the situation. These bold decisions that have been taken on the guarantees and the recapitalization schemes went through the different democratic processes quite nicely all over Europe. We had no difficulty of the U.S. type with the first refusal of the package by the Congress. I would say the decentralized system of European decisions proves effective under stress.