Wednesday, June 6, 2007

ECB Raises Rates 25 Basis Points

From Dow Jones:

The European Central Bank raised interest rates 25 basis points Wednesday, just as markets had expected.

The ECB increased the key refinancing minimum bid rate to 4.00% from 3.75%. Likewise, it raised the deposit rate to 3.00% from 2.75%, and the marginal lending rate to 5.00% from 4.75%.

Markets considered Wednesday's hike a foregone conclusion after European Central Bank President Jean-Claude Trichet signaled the move last month by saying the ECB would use "vigilance" in monitoring price risks. That word has heralded each of the past rate increases.

The ECB has raised interest rates eight times by 25 basis points since the start to monetary tightening in December 2005.

This ties in nicely with the following story from today's WSJ:

For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation. Now that damper on prices is beginning to reverse -- and global inflation pressure is starting to build.

Companies in many countries are operating at close to full capacity, facing shortages of everything from land to equipment. Western workers and their low-cost rivals both are winning higher pay, thanks to rising demand. In some cases, the global links of the economy are increasing costs rather than lowering them, as far-flung businesses compete for the same resources.

Central banks are increasingly worried about spare production capacity running out -- which could force them to raise rates to their highest level in years to stave off inflation. That could puncture the ebullience of stock and bond markets, which have become accustomed to a rare combination of fast growth, low inflation and low interest rates.

Already long-term interest rates are on the rise, in anticipation: U.S. 10-year Treasury bonds hit a nine-month high of nearly 5% yesterday. "Markets have gotten used to the idea that the global economy will keep producing downward pressure on prices," says Ken Rogoff, a Harvard economics professor and former chief economist at the International Monetary Fund. "But that phase may be ending.

US interest rates are on the rise and have been the topic of much discussion among market watchers (I discussed them here). Although there is a concern about US interest rates right now, it's important to note the 5% isn't that expensive. In fact, I don't think rates of 6% are that bad either. That being said.....

The WSJ article points out three really interesting developments from globalization.

1.) Increased resource competition. As China and India heat up they will demand more raw materials. Considering these countries have a combined population of about 2 billion, that increased consumption of raw materials will have a tremendous effect on the overall world economy. It explains why the current US rally is largely a basic materials rally compared to the 1990s which was a technology rally. Simply put, there are more companies competing for resources now, which drives up prices, which increases inflation.

2.) Overall US Inflation isn't that high. But the Federal Reserve is attempting to cut increases off before they happen. Ever since Volcker crushed inflation in the early 1980s, the US economy has enjoyed a tremendous period of low-inflation and good overall growth. One of the reasons for that growth is lower inflation expectations. The Fed wants to keep it that way, as do other central bankers.

3.) Notice the effects in the production countries:

Western workers and their low-cost rivals both are winning higher pay, thanks to rising demand.

China and India have a long way to go until they reach parity with the US. However, it's clear that eastern wages are increasing which raises their standard of living. My guess is China and India are focusing on the really big picture economically -- as in decades. They realize the current generation and probably the next will not enjoy a western style standards of living. However, these countries are looking to 2050 or so and appear to be implementing policies with that year in mind. This is the same planning strategy other Asian Tigers employed starting in the 1960s with tremendous results.