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Are ECB Hawks Banking on the Wrong Problem?

Thursday, 9 Jun 2011 | 2:16 AM ET

Whilst the Bank of England sits on the sidelines, the boss of the European Central Bank (ECB) on Thursday is expected to signal he will raise rates next month to curb inflationary pressures.

European Central Bank
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European Central Bank

At a time when the data are pointing to a slowdown at best, one analyst believes the ECB is about to make a major mistake by raising rates despite the crisis facing the euro zone’s periphery.

"The ECB should, in our view, consider the threats being posed to the region's banking system as being both significant and a source of potentially considerable deflation, irrespective of the perceived cost pressures that bubble to the surface from time to time," Jeremy Batstone-Carr, an analyst at Charles Stanley, said in a research note.

"Despite the fact that two member states are on the brink of collapse, the ultra-inflationists at the Bundesbank continue to struggle to see anything in the region's tea leaves apart from the suggestion that inflation risk is imminent," he said.

With energy prices already elevated—and, in Batstone-Carr's opinion, possibly moving even higher—the far bigger risk is a second credit crisis,in which banks stop issuing loans.

"Just as we witnessed in 2008-09, a banking sector credit crunch destroys demand and jobs instantaneously," Batstone-Carr said. "Price increases there may be, but these will not be passed on to consumers if crisis conditions reassert themselves."

"Persistent demand for short-term cash at the ECB's weekly refinancing window confirms that a large proportion of regional banks are struggling for liquidity, while domestic credit data confirms that the banks are not lending to the private sector," he added.

This suggests to Batstone-Carr that the bigger risk for the ECB is the banking sector, not rising prices. "It seems, in our view, that the more probable crisis facing the ECB is not inflation so much as a failure in the region’s banking system caused by sovereign default," he said.

"The ECB’s inflation mandate is symmetrical: It is required to guard against potential deflation as well as inflation. Were a Lehman Brothers event to hit the euro zone a credit crunch would almost certainly ensue, resulting in a pronounced economic contraction on top of the one the global economy is still attempting to escape from," he said.

"Were the risk of sovereign default small then we might be minded to agree with the ECB as it obsesses regarding the potential threat posed by cost-push inflation," Batstone-Carr said. "However, the situation in Greece has reached criticality. Although some in the markets believe that the Greek fiscal crisis has been resolved the reality is that it absolutely has not."