Commenting in this morning’s Financial Times on Mr Weidmann’s decision to vote against the European Central Bank’s Outright Monetary Transactions (OMTs) initiative, Wolfgang Munchau notes that; ‘… the ‘consensus view among German commentators is that the ECB has lost its independence …’. It might be put otherwise.
It is not that the ECB has lost its independence – certainly Mr Draghi would take issue with this – but that the Bundesbank has lost is authority over ECB monetary policy and that this might be hard to swallow. Let’s now hope that Germany’s Constitutional Court does not decide to throw a spanner in the works.
This Wednesday, Germany’s Constitutional Court will finally rule on the legality of the European Stability Mechanism (ESM), as well as on the fiscal compact. The ESM was supposed to start life in July but has since been hung up in the German Court. While a favourable ruling is not a done deal necessarily, Germany’s Finance Minister has actually said, quite directly, that he was sure the Court would approve.
What matters is that any qualification or condition that might be associated with a favourable ruling does not interfere with what Mr Draghi hopes will be perceived as a ‘fully effective backstop that removes tail risk from the euro area.’ The ESM is a critical agent of the entire support operation in assisting sovereigns and in dealing with market fragmentation. It thus needs an endorsement that enables it to respond without shackles that might undermine the entire capability of what the ECB intends.
Wednesday is also an election day for the Dutch. The latest from the weekend polls shows that the Liberal Party, led by the Mark Rutte, the (caretaker) Prime Minister, and the Labour Party, would each win 35 of the 150 seats in Parliament. A Liberal/Labour led coalition might work. Both parties are pro-eurozone with the difference between them being their positions on the pace of fiscal adjustment. While the Liberals are hard line in their support for fiscal discipline, Labour believes the pace for achieving budget deficit targets needs to be eased and the time for achieving them extended.
On Thursday the FOMC meets to review policy. If the Fed is as ‘gravely concerned’ as Mr Bernanke recently indicated, then last Friday’s Non-Farm Payrolls will be seen as the disappointment it was. The market talk is now of an open-ended commitment of the order of US$50 billion monthly purchases of Treasuries and/or Mortgage-Backed Securities.
This leads to a point raised in last Monday’s Market Tactics which was that, in anticipating the well-leaked participation of the ECB, equity markets might be taking on board the significance of the full collective force of the monetary policies of the major central banks, a force that, in one way or another, is being geared towards the eventual reflation of aggregate demand.
Since then, the leading Wall Street Indices have gone on to reach new post-financial crisis highs and the market dynamics, as illustrated with the price relative, as shown below, for the FTSE 250 against the FTSE 100 because of the concentration of cyclicals in the former and defensives in the latter, has come through with a little more verve than before. By the end of last week, the FTSE 250 (with and without investment trusts) had reached a new high for the year.
In one respect the full force of monetary policy may not be quite in place. More evidence that China’s loss of momentum has extended into the third quarter of the year came with the news over the weekend that growth of industrial output for August was at its slowest pace since May 2009. Other figures, such as retail sales for August, as well as this morning’s data for trade showing falling imports, reinforced the comments made by China’s President on the weakening state of domestic demand.

China’s policy response has been mixed with the authorities appearing more ready to support domestic demand with fiscal stimulus than through monetary policy. On the face of it, the latter appears to be less pro-active. But that may be more apparent than real. Maybe the central bank is mindful of money supply growth, which is picking up, and residential property prices, which appear to be stabilising. Inflation rose modestly in August to 2 percent from July’s 1.8 percent though it remains well below target.
It is easy to forget that China’s target growth rate for 2012 has been lowered to 7.5 percent and that policy aims to stabilise rather than stimulate growth. As it is not yet clear that this is being achieved, the central bank may soon choose to take out insurance with more cuts in reserve requirement ratios and/or in interest rates.
For markets, the key this week has got to be the ruling by Germany’s Constitutional Court on the legality of the ESM and anything less than an unqualified endorsement will be treated as bad news. Achieving credibility with the ECB’s new initiative will be hard enough without more obstacles. The ESM needs a green light, not doubts as to its capability or any impediment as a critical instrument for effecting ECB policy. If it gets it, equity markets should fly and the rotation towards cyclicals, as reflected already by the relative performance of the FTSE 250, should continue and broaden.

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