Trichet’s Smackdown?

Watching commodity prices fall off a cliff today inspired us to gather some evidence for our offhand observation that the rolling over began in July, when the ECB raised rates to combat inflationary pressures (an issue we briefly commented on yesterday). This assertion is based on timing, and is supported by the intellectual and institutional foundations of the ECB, which are clearly of a neoclassical and monetarist bent, as embodied in its mandate to focus solely on price stability.

Graphically, it does look like the ECB’s actions played a decisive role, as gold began to fall rapidly after the ECB rate announcement (down over 10% since July). However, the Euro/USD exchange rate has moved in favor of the dollar, an unusual development when gold is falling.

So did Trichet smack down both commodities and the Euro last month? Hard to say. It’s well established that both commodity prices and foreign exchange ratestent to "overshoot" in response to monetary shocks, and after a huge run up, gold did appear to be trending down before the ECB’s July rate hike. However, the importance of the ECB’s direction shouldn’t be understated. Fact is, there are now two central banks setting monetary policy for the world, and to have them moving in opposite directions means that the marginal cost of money is going to lie somewhere between their target rates. By hiking while the Fed stood still, Trichet raised that marginal cost, which should have a negative impact on commodity prices. But it could also have a very negative impact on the eurozone economy. 

In fact, we suspect that much of the current market turmoil is due to uncertainty about future policy direction from the ECB. As an institution, it is designed to be far more resistant to political pressure than the Federal Reserve is. Will it be able to maintain this, given the pessimistic expectations developing in Europe? Time will tell. If so, we’d expect the USD rally to be relatively short lived, and for commodity prices to stabilize. If not, we’d expect exchange rates to become especially volatile, and for global inflation pressures to rebuild.