Markets have obviously also been keen to see a short-term liquidity
boost in terms of ramped up European Central Bank bond buying but what
they got was the ECB being prepared to lend a lot more, at term, to the
banking system.

He doesn’t think that there is an overt ECB strategy to get the
banks to do the bond buying on its behalf, although he does admit that
national debt offices are often in a position to ‘arm twist’ market
makers.

A long-term solution to the underlying competitiveness problem of
the periphery is “still missing”, he says.

Big falls in wages and prices will be needed to devalue the real
exchange rate in the zone’s periphery. While some of that has been
achieved in Ireland, “it’s not really been done in any other country
yet”.

What is needed is something along the lines of IMF conditionality
to enforce, because the ECB is in no position to do so.

His message now is that all the options to resolve or end the
crisis are “painful ones” – but, he adds, “some are less painful than
others”.

“You can imagine some very disorderly scenarios – we try not to go
there too much but you can’t ignore that as a possibility”.

One way or another euro area governments have to do “enough to give
their investors confidence”.

“If they want to preserve the single currency, they have got to get
capital – private or public – to flow to those countries which have
large current account deficits,” he said.

But, Fisher continues – “It’s a very difficult situation for them
and it’s very easy to criticise. We have been careful not to say things
which would make the situation worse.”

“There are strategies which could work”.

Fisher’s reading of the present market view is that “things will
run along as they are and slowly get sorted out”.

The attitude among many market players has been that “it is
harder to forecast politics than economics” and some have said ‘I don’t
want to play this game’.

“This is why markets have been so thin and volatile”.

Sometime in the summer of this year there was a general loss of
confidence in the ability of the authorities to solve the present
crisis, triggered mainly by concerns over Italy’s public finances.

When central banks have effectively got together on a global basis,
as they did in their recent coordinated steps to boost U.S. dollar swap
lines, this has been received very positively by the markets.

“It demonstrates what the markets are looking for,” he says.

But there are limits on what central banks can do. They can only
provide the “economic conditions under which real economic adjustments
can be made”.

The BOE’s Quantitative Easing policy only works because the bank
has a credible inflation target and well-anchored expectations around
that target.

“We went into this crisis with inflation under some measure of
control”.

“We have been able to look through the price shocks because
inflation expectations are so well-anchored,” he says.

This is unlike the recession of the 1980’s when the effectiveness
of monetary policy had been constrained by inflation at the 20% rather
than the present 5% level.

“Even now it is very important that inflation comes down. If it
doesn’t then we will have to look at the policy stance,” Fisher says,
reiterating the view of the Monetary Policy Committee that it wants to
be certain that inflation will indeed decline in line with its forecast.

While he is “pretty sure” inflation will fall and fall sharply as
VAT and other base effects drop out of the annual comparison at the
start of 2012, the question is “where does it fall to”.

There is little sign of inflationary pressure from demand or wages,
he notes.

On the other hand, the Eurozone crisis could present the economy
with another negative shock “which pushes us into recession and
deflation”.

This is the “bigger risk at the moment than inflation staying at
5%”.

Should the UK economy “get stuck into recession and deflation,
having already done a lot of QE to prevent it – errrr – what’s plan B
then? – you’d have to have something more radical to try and get out
of it”.

The biggest threat remains deflation, he says.

And this means that the FPC is starting out at exactly the most
difficult time.

Former Fed Chairman William McChesney Martin talked of the central
bank’s job being to take away the punch bowl just as the party got
going.

The FPC is “trying to cure the hangover”.

–London newsroom 0044 20 7862 7492; email: dthomas@marketnews.com

[TOPICS: M$B$$$,M$$BE$,MT$$$$]