Trichet Adopts Greenspan Strategy as ECB Readies Price Attack

By Simon Kennedy

July 3 (Bloomberg) -- European Central Bank President Jean- Claude Trichet may be taking a leaf from former Federal Reserve Chairman Alan Greenspan's playbook.

Trichet is poised to raise interest rates today to stem inflation even as economic growth slows. Lehman Brothers Holdings Inc. and ING Bank say that in doing so, he would be adopting Greenspan's strategy of taking out insurance against events that have little chance of occurring, yet pose high risks if they do.

The ECB's worst-case scenario is that inflation concerns fail to dissipate and become embedded in the 15-nation economy, sparking a wage-price spiral that requires even higher rates later if not quashed now. The cost of ensuring that doesn't happen may be weaker growth.

``The ECB is pursuing a risk-management approach to monetary policy,'' said Martin van Vliet, an economist at ING in Amsterdam. ``They are determined to prevent higher inflation expectations from becoming self-fulfilling. Prevention is better than cure.''

The ECB announces its decision at 1:45 p.m. in Frankfurt and Trichet holds a press conference 45 minutes later. All but one of 58 economists surveyed by Bloomberg News predict a quarter-point increase in the benchmark rate to 4.25 percent.

Trichet took economists by surprise last month when he said the ECB may raise rates. Since then, inflation has accelerated to 4 percent -- the fastest in 16 years and double the bank's limit.

Oil Shock

As food and oil prices set records, policy makers have said they intend to restrain inflation expectations amid concern workers will demand more pay. Their nightmare is a repeat of the 1970s, when officials accommodated surging energy costs only to have to stomp harder on the economy to control prices later.

``We must avoid unanchoring inflation expectations,'' Trichet said on June 5. ``You can date from the first oil shock the start of much lower growth and mass unemployment.''

Expectations have already started to slip their moorings. The outlook, as measured by the break-even on French five-year inflation-indexed bonds, jumped to a record 2.78 percent this week from 2.12 percent in March.

While arguing expectations are still ``well anchored'' in the longer term, Michael Hume, chief European economist at Lehman Brothers, said there's enough motivation for the ECB to risk a sharper economic slowdown by raising rates.

``With inflation risks now rising, policy may need to be used to give it an extra nudge down,'' said Hume. ``Like the Fed, we expect them to succeed in managing risk, but in doing so, it seems likely they will ultimately cause growth to weaken by too much.''

Greenspan Legacy

Overshooting is one of the downsides to risk management, which was formulated by Greenspan when he ran the Fed for 18 years. ``A central bank needs to consider not only the most likely future path for the economy, but also the distribution of possible outcomes about that path,'' he said in a 2005 speech.

His successor, Ben S. Bernanke, adopted a similar strategy in chopping the Fed's main rate seven times since September in an effort to avoid a recession. The Fed, which unlike the ECB has the task of both controlling inflation and fostering growth, has sometimes paid for insuring against risks.

It cut its benchmark rate to a 45-year low of 1 percent in 2003 to fend off deflation, only to fuel a mortgage boom that turned to bust. Its 1998 bid to counter a credit-market collapse after Russia defaulted was followed by 4.5 percent growth and faster inflation in 1999.

`Amplify Cycles'

``Risk management policies are misguided in that they are an attempt to fine tune the economy, yet usually exacerbate problems and amplify cycles,'' said Bob Eisenbeis, former head of research at the Atlanta Fed and now chief monetary economist at Cumberland Advisors Inc. in Vineland, New Jersey.

Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York, said the ECB is making that mistake.

He estimates 88 percent of the increase in commodity prices isn't translated into broader inflation and blames Trichet for fanning price fears. ``Hiking rates now is a policy error,'' said Weinberg.

Hume predicts the ECB will start cutting rates in January. The economy is already stumbling. Confidence among businesses and households fell to a three-year low in June, retail sales plunged and manufacturing and service industries contracted.

Risk management ``implies plenty of policy flexibility and volatility, both in terms of heading off the risk and removing the insurance once the risk has passed,'' said Hume.

Investors disagree. They've priced in two rate increases to 4.5 percent by the end of the year and most are betting on a third by March, Eonia forward contracts show.

Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt, said the ECB may be happy to pay the price of slower growth to tame inflation. Labor costs rose the most in five years in the first quarter and oil this week reached a record of more than $144 a barrel.

``It seems that a severe economic slowdown is not only tolerated, but possibly even needed to anchor inflation expectations,'' Guntermann said.

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net