Recession or Stagflation?

The ECB and the Bank of England have joined the chorus of central banks that have opted to keep interest rates steady (or in observation mode) in what seems to be a bid to preserving price stability amidst clear signs of further economic deterioration.

With the sharp rise in the dollar and a steady decline in Euro rates, markets seem to be anticipating that ECB rate cuts are not far away. The same seems to apply for the Fed, observed by the steady erosion in treasury yields (in stark contrast with just a short while back when markets were adamant that the Fed would tighten before year end). The strengthening dollar, however, suggests that the European slowdown could be nastier than that of the U.S., which should come as no surprise considering that the U.S. is ahead of Europe in terms of the business cycle and the ECB target rate was and remains significantly above that of its U.S. counterpart (further choking an already sputtering economy).

So what sparked a change in monetary policy (switching from tightening to steady in Europe and from loosening to steady in the U.S.) and the shift in market expectations? The single largest factor seems to be the sharp reversal in commodities (most notably oil and gas). The drop seems to have subdued inflation worries and, combined with the now global economic slowdown, has shifted market concern from inflation back to the economy. Supply shocks tend to work with lags (as observed with the so far tepid rise in the core inflation rate) which means that even with the marked drop in oil prices, it will take time to impact core inflation. In the meantime we may observe a further rise in the core.
In terms of interest rate policy we believe that in the present context, there is far greater risk of a full blown recession than a risk of stagflation and therefore think that the Fed's strategy (maintaining a loose monetary policy) is way sounder than that of the ECB.