Last Thursday, ECB Chief Jean Claude Trichet was dismissive over the deflationary signals being sent from the EZ economy, noting the negative rates in the recent PPI readings are a natural result of the recent economic contraction and will disappear soon.  At the time we were high skeptical of ECB’s policy stance, noting that deflation rather than inflation was a far greater threat to the EZ economy for the foreseeable future. Today’ s news and analysis from the region confirms our doubts. (Hat tip to our friend Rhoda Staskow for the roundup)

In an article in FT European corporate leaders   note that the high value of the EUR/USD which has hovered  near the top of its 1.25-1.40 range for the past several months is now starting to impact profit margins as European exporters struggle to win business. The export sector   is the primary driver of growth in the region and we have argued for a long time that persistently high exchange rates will prove to be a massive barrier to growth for the EZ economy especially in the current environment of depressed global demand.  Additionally, a study from Fribourg university notes that goods prices are falling at record pace in Germany while Commerzbank predicts that real wages in Germany  will contract  this year.

ECB’s ardent anti-inflationary posture, at a time when price levels are actually negative reminds us of generals who are always fighting the last war. The Budesbanker philosophy of the ECB continues to influenced by the hyperinflation disaster of the 1920’s, while the current economic reality suggests that the monetary policy  is too restrictive given the deflationary forces in the system. The net result of this dynamic is that despite Mr. Trichet’s assurances, that interest rates in the region are “appropriate”, the ECB may be forced to lower them beyond the current 1% barrier as it moves inexorably towards ZIRP. The currency markets may already be anticipating this move  with EUR/USD sharply lower at the start of the week as the recovery story starts to falter and the market reassess its enthusiasm towards risk in the second half of the year.

Source: FX360.com