December 8, 2006
THE BIG SQUEEZE
The European Central Bank raised its main rate by 25 basis points yesterday, bringing the price of money on the Continent to 3.5%. Meanwhile, Fed funds continue to tread water at 5.25%.
The spread between the primary interest rates for the planet's leading currencies is now just 175 basis points, and a further narrowing is expected in 2007. The ongoing tapering appears set to come from both sides of the Atlantic: hikes from the ECB and holding steady at the Fed. In fact, the trend may be accelerated if Bernanke and company decide to cut rates next year, as some strategists are predicting.
The implications of a narrowing spread between U.S. and European rates are many, including increased pressure on the dollar. If euro-denominated debt continues to offer increasingly higher yields while dollar-based bonds remain more or less unchanged, forex traders and other overseers of capital will presumably adjust their decisions accordingly. The current choice stacks up as follows: a 10-year Treasury yields 4.63% vs. 3.75% for the equivalent in Germany. There's still a premium in the U.S., but if it fades further, the realignment currently underway in the greenback could accelerate.
If the only variable in the world was interest-rate spreads, the Federal Reserve might very well decide to raise rates if only to defend the dollar. But the global economy's more than a one-factor model. Among the additional complications: domestic inflation. On that note, The New York Times noted today, wage pressures are building. "After four years in which pay failed to keep pace with price increases, wages for most American workers have begun rising significantly faster than inflation," the Times reported.
If the trend has legs, as the article suggested, might it complicate the Fed's monetary policy in 2007? It might if the ECB continues raising rates, the U.S. economy continues slowing and core inflation continues rising, as it has in 2006. The scenario just described, if it remains intact, promises to bedevil the Fed, and everyone else who holds dollar-denominated assets.
Posted by jp at December 8, 2006 7:14 AM
Rising wages aren't a problem for workers, but they could pose a challenge for the Fed at this particular moment. The reason is that the Fed may want/need to lower interest rates if the economy continues slowing. But lowering interest rates won't be prudent if inflation doesn't cool.
There are many factors that may influence inflationary pressures. But at the end of the day, the buck stops (literally and figuratively) at the Fed. It's a central bank's job to stop inflationary pressures in their tracks. The reason: price changes, up or down, should be driven by supply and demand rather than inflation.
In sum, there's no reason that wages rising faster than inflation should be an inflation problem for the economy--assuming that the Fed takes a stand and draws a line in the monetary sand. We'll see.
Posted by: Jim Picerno at December 9, 2006 1:47 PM
Why is rising wages a problem? I thought we want workers to have higher wages. If wages aren't rising faster than inflation, workers are falling behind. If it's rising as fast as inflation, workers are treading water.
Are there any economists out there that think inflation is caused by anything but the Federal Reserve? How else can you achieve a general rise in the price level except by debasing the currency? Everything else is a function of supply and demand, and rises in one area result in decreases elsewhere. There are factors like productivity or taxes, which could cause a general decline in the price level (or rise if you carpet bombed the manufacturing centers or taxed them back to the stoneage). But these are just supply and demand shocks.
Posted by: Free the Market at December 8, 2006 5:13 PM