The dangerous ECB game

The European central bank held rates at 4.25 percent to continue its fight against inflation. They raised rates last month. This was within expectations and consistent with their focus on inflation. Inflation is above the target level and at the highest level in sixteen years; nevertheless, this inflation targeting is a dangerous game for anyone worried about economic growth. The numbers in European are showing a slowdown and a lack of confidence in the potential for growth. The equity markest in Europe have been much worse than the US given this tight money policy. The combination of higher energy costs and a strong euro which cuts into the key export sector has led to a business cycle that is more like the US. Additionally, there are areas in Europe which have seen a housing bubble. The credit issues of the US have been and will continue to be faced by many of the banks in Europe so lending activity will be tight over the next few quarters.

We expect that business cycles in Europe and the US will move more in tandem. This means that that the euro will be generally have upward pressure given the higher interest rates relative to the US. The Fed is also likely to be on hold for what may be the remainder of the year so the interest differential between the two currency areas will stay range-bound.