Bernard Godement sent me his thoughts, from a recent Nikkei op-ed:
There thus appear to be only two possible cases going forward.
In the first case, China continues growing rapidly in 2005 – say 8% to 9% - and oil prices have few chances indeed of falling. But a continued Chinese current account surplus and inflows of hot money allow China to keep subsidising the dollar through reserve accumulation. This is of course the nice scenario for Asia, but compared to the ECB projections, it means that oil prices are higher than assumed. Activity in Europe is thus lower than expected and, though CPI inflation suffers from higher oil prices, labor costs remain better contained because the labour market remains ugly. Does the ECB ease policy in such a situtation ? Possibly formally through a slight (25 bp) cut in nominal rates, assuredly in reality by accepting the fall into negative territory of real interest rates that would be implied by CPI inflation rising above 2% (the key interest rate of the ECB is presently 2%).
In the second case, the Chinese economy slows down for some reason. Possibly because the contradiction between real estate prices and household income and resources gets resolved through the popping of a bubble. Whatever. In such a case, hot money likely reverses direction, Chinese reserve accumulation slows down significantly from the USD 200 billion recorded in 2004 (there go Renminbi revaluation expectations…), and the ultimate result is that the financing of the US current account requires the USD to fall down quite a ways. The EUR exchange rate thus appreciates significantly, and Euro GDP growth remains a disaster area. With a slower Chinese economy come lower oil prices, and therefore Euro area CPI inflation retreats significantly and of course there suddenly appears the need to cut interest rates in a hurry.
In response to an earlier post noting ECB president Trichet's tough talk on the possibility of a rate hike, Bernard had this to say:
Now Trichet can decide to tighten anyway due to a weakening of the stability pact. He can decide to get into an open conflict with the fiscal policymakers. It does not really matter to my scenario. Because, give it six to twelve months, he will be facing such a weak economy that he will be forced to reverse direction.
OK. You heard it here.
(Note to Bernard: Thanks for sending that my way -- do you know if there is a public link to the article?)
(Note to pgl: So the ECB, in effect, loses the game of chicken?)