Why the ECB watches the Fed.

Following European Central Bank (ECB) policy closely these days is no easy task. Some policymakers seem fixated on controlling the monetary aggregates and have argued for higher short term interest rates to further sop up an oversupply of liquidity. Others have suggested that because high energy prices produce higher headline inflation, which has a way of seeping into the system and producing upward pressure on core inflation, the ECB should further raise rates. Others suggest that the central bank should further raise short-term rates as means of sending labor a message to back off excessive wage demands.

But at the end of the day, when all is said and done, what one variable drives ECB policy decisionmaking? More than a few strategists acknowledged that the ECB is closely watching developments at the Federal Reserve. European short-term rates will continue to rise into 2007, strategists say, unless one development unfolds--the Fed starts broadly hinting that it will soon begin to reduce short-term rates. "Despite the ECB's independence, there is no way the European system will or can tolerate for very long a dramatic strengthening of the euro," a European strategist said. "That's why the ECB watches the Fed."