Fortune Europe editor
March 18, 2008: 2:15 PM EDT
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Fed cuts, but Europe holds tight

The issue of bank failures versus inflation looks much different on opposite sides of the Atlantic. Here's why.

By Peter Gumbel, European editor

European Central Bank president Jean-Claude Trichet views inflation as a greater threat than does his U.S. counterpart Ben Bernanke.

PARIS (Fortune) -- Quick, what's worse: a banking collapse or soaring food prices? If you're the Federal Reserve, that's no longer even a question. By tossing Bear Stearns (BSC, Fortune 500) a lifeline this weekend and then throwing much of the contents of its monetary toolbox into the market- including Tuesday's three-quarters-of-a-point cut - the Fed demonstrated its overriding priority: forestalling a growing financial and economic crisis in the U.S.

But across the Atlantic at the European Central Bank in Frankfurt, Germany, the story is different: there, it's those food prices that cause sleepless nights. Sure, European central bankers are nervous about disorderly financial markets and the threats they could pose to the world's financial system. Indeed, the ECB acted faster than the Fed to inject liquidity into the banking sector last August at the first sign of an international credit crunch.

But when it comes to its interest-rate policy, the bank seems more worried by the specter of rising inflation in Europe - which hit an annual rate of 3.3% in February - and is balking at following the Fed in cutting rates even though the European economy is showing signs of distress. "The inflation focus will likely keep rates on hold for now," Deutsche Bank economists said in a report this week, predicting that the ECB won't begin cutting rates until the third quarter of this year.

The divergent world views and approaches of the world's two key central banks aren't especially helpful at a tense time for the global financial system. The banks are in constant touch with each other and have worked together since the beginning of the credit crisis to ensure that financial players around the globe have ample liquidity at their disposal.

Is inflation so bad?

Still, at the very least, the interest rate differential between the U.S. and the euro-zone countries is one factor that has driven the dollar down to record lows this week. And if your life savings have just been wiped out because they were invested in Bear Stearns stock, you can be excused for thinking: "geez, 3% inflation, what's so bad about that?"

Behind this divergence are several critical differences. The ECB's culture, largely inherited from the former German central bank, is more inflation-averse than the Fed and slower to ride to the rescue of a faltering economy. And, seen from Frankfurt, the European banking sector's problems seem far less dire than those of U.S. banks. There have been some nasty surprises - anyone remember Northern Rock? - and other European banks including HSBC, Crédit Agricole and Germany's Commerzbank have taken some big subprime writedowns. But even the biggest losses at these banks have been manageable because European financial institutions tend to be conglomerates that combine retail banking and asset management, and are thus less vulnerable to a big loss in any one line.

Moreover, bankers say that European regulators were quick to urge banks across the continent to be far more transparent with one another, both formally in what they publish and informally, around the table, in disclosing their potential exposure to U.S.-originated credit losses. In France, for example, the central bank called in the heads of all major French banks at an early stage in the crisis to exchange information in a bid to restore confidence, according to people involved in the talks. One result is that even Société Générale, hit by a double whammy of subprime losses and a rogue trader who racked up $7 billion in losses, has managed to survive and raise fresh capital this month without much difficulty in a falling market.

Some Europeans want cuts

Of course, the ECB's policy of keeping interest rates relatively high - the main refinancing rate for banks in Europe has remained unchanged at 4% for the past nine months - causes strains of its own. Germany, the continent's biggest economy, has been booming, and can easily deal with a relatively high interest rate level. But other European economies including Italy's are faltering, and have a hard time coping with expensive money. Indeed, French president Nicolas Sarkozy has been vocal in calling for the ECB to cut rates in order to give a boost to the European economy, which is flagging overall despite Germany's continued robustness.

And so what would be so bad about a small uptick in inflation? ECB president Jean-Claude Trichet gave at least some of the answer in a speech in Barcelona last month that has since been much picked-over. He discussed the economic evidence that suggested that inflation worldwide had been kept in check for a long spell thanks to low-price imports from emerging markets such as China which had a disinflationary impact.

But, in Trichet's view, that period is now over - and we are moving into a much more dangerous one in which increasing inflationary pressures in emerging markets are spilling over to Europe and the rest of the world. Combined with rising food and other commodity prices, Trichet said, "these developments clearly represent upside risks to price stability."

The upshot is that if the European view is right, the Fed could soon have a huge inflation headache once the current Wall Street crisis has been tamed. But that's only if the Fed does first manage to save Wall Street and restore confidence and trust in U.S. banks. If it doesn't, all bets are off - inflation or no inflation.  To top of page

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