Different approaches to inflation

Meanwhile, across the Atlantic, the European Central Bank (ECB) is focusing its attention elsewhere. On Jan. 31, the European Union's official statistics agency Eurostat released news that the annual consumer price increase in the Eurozone reached a record 3.2 percent in January, up from December’s 3.1 percent rise, which is a preliminary estimate. This is significant as the ECB defines price stability as an inflation ceiling below 2.0 percent. European central bankers expressed concerns about the jump but also said the data was not a surprise given the rising global food and energy prices. Market watchers say current actions highlight the differing approaches of the U.S. Federal Reserve and the ECB right now. While the Fed has slashed the federal funds rate 125 bp in less than two weeks amid efforts to stave off recession, the ECB remains firmly focused on the threat of inflation. The ECB has left interest rates unchanged at 4.00 percent since June 2007, despite recent cuts by the U.S. Federal Reserve, the Bank of England, and the Bank of Canada.

The two central banks actually have differing mandates, which may underlie their current postures. While the Fed has a dual mandate of supporting growth and controlling inflation, the ECB has only one mandate: to keep prices steady. Following its mandate, the ECB has been on the record with extremely hawkish comments in recent weeks and months, and has followed up with steady monetary policy. Nonetheless the market is expecting a rate cut from the ECB in the second quarter, as expectations are the weakening U.S. economy will trickle over into the already weakening Eurozone growth picture. Jones says most people feel the ECB will eventually have to cut, despite its hawkish talk.

While “the fear is the Fed is paying no attention to inflation, the ECB is 180 degrees the other way: the sole focus is on inflation,” explains Thomson FX Hub’s Coleman.

However, “given that the Fed has responded aggressively [to concerns regarding economic weakness], they are really taking a gamble, because consumer inflation is high,” says Michael Woolfolk, senior currency strategist at the Bank of New York Mellon. “Their assumption is that inflation will moderate on weaker growth.”

The latest U.S. core PCE reading, which measures prices paid by individuals, revealed a 2.7-percent jump in the fourth quarter. That measure is known to be one of the Fed’s favorite indicators, but their traditional “comfort zone” tends to be 1-2 percent on an annualized basis.

Shifting back across the Atlantic, the ECB is set to meet next on Feb. 7, but market expectations are for steady policy. When asked if a rate cut was possible this soon in light of recent European inflation numbers, David Powell, currency strategist at Ideaglobal responded: “No, not a single person in the world expects them to cut rates. The market expects a 25 basis-point cut in June and then another in September. Nobody expects a cut next week.”