SERIOUS MONEY:JEAN-CLAUDE TRICHET, president of the European Central Bank (ECB), surprised financial markets last week when he revealed the bank's governing council is increasingly uncomfortable with interest rates at emergency levels. Following the monetary policy meeting last week, Trichet delivered a shot across the bow when he pronounced that "strong vigilance is warranted with a view to containing upside risks to price stability", and declared that the ECB is "prepared to act in a firm and timely manner".
The message is clear – the central bank is prepared to launch a pre-emptive strike to anchor inflation expectations and a quarter percentage point increase in the refinancing rate to 1.25 per cent at the next meeting of the governing council on April 7th is virtually assured.
ECB governing council members had been increasingly vocal on heightened inflation risks in the days leading up to the most recent meeting. The increasingly hawkish rhetoric was precipitated by the significant acceleration in headline inflation in recent months. Indeed, euro zone inflation has jumped by half a percentage point over the past three months and by one percentage point over the last year to 2.4 per cent in February.
The upward trajectory in prices saw ECB staff raise their latest mid-interval inflation forecasts by half a percentage point to 2.3 per cent in 2011 and by 20 basis points to 1.7 per cent in 2012. Although these projections do not appear to be particularly alarming, the ECB is clearly not comfortable with the upper boundary of 2.4 per cent in 2012.
Furthermore, the recent forecasts were made before the recent surge in oil prices in the midst of political upheaval in the Middle East and North Africa region and though there is little evidence to date of any second-round effects, with core inflation running at little more than 1 per cent year-on-year, the central bank undoubtedly believes that prevention is better than cure.
The risk that higher oil prices may feed through to core inflation appears to be a function of the improving growth outlook. Although the euro zone expanded at a quarterly rate of just 0.3 per cent during the final three months of 2010, activity was adversely affected by the exceptionally harsh winter weather, while forward-looking indicators suggest that growth could well be stronger-than-expected in the months ahead. Indeed, the composite purchasing managers’ (PMI) index is at the highest level since July 2006 and is consistent with a quarterly growth rate of 0.8 per cent.
The ECB appears to be troubled by the fact that the positive economic momentum is allowing companies to respond to the sharp rise in input costs and raise output prices at a more rapid pace than previously. Indeed, the composite PMI output price index is close to the level that was registered during the summer of 2008, when the monetary authority last increased interest rates to anchor inflation expectations against a background of high and rising oil prices.
An increase in the policy rate from the historical low that has been in place since May 2009 would appear to be appropriate in light of the above, but the sense of urgency is difficult to justify given the considerable slack in the labour market, a still-impaired credit transmission mechanism, not to mention the negative economic impulse that is certain to follow the planned fiscal tightening throughout the region.
The unemployment rate is close to 10 per cent today as against the 7.5 per cent in the summer of 2008 when the ECB last tightened policy. The excess supply of labour means that wage demands are being kept in check and modest compensation growth combined with a cyclical uptick in productivity has seen unit labour costs decline for three consecutive quarters, which compares with increases of 4.5 per cent in the middle of 2008. Furthermore, the slack in the labour market means that increases in oil prices are unlikely to translate to higher wage growth; they are far more likely to reduce consumers’ purchasing power and act as a drag on economic growth.
It is also noteworthy that the ECB’s increasingly hawkish stance is not supported by monetary developments. First, growth in the money supply can be described as tepid at best, with M3 increasing at an average rate of just 1.7 per cent year-on-year over the past three months, as compared with a medium-term reference of 4.5 per cent. Second, lending to the private sector is expanding at a moderate pace with an average growth rate of little more than 2 per cent year-on-year in the most recent three-month period as against a growth rate of close to 10 per cent from 2006 to early 2008.
The ECB is set to tighten monetary policy as early as next month in an effort to enhance its price-stability credentials.
It is not clear however, that the sense of urgency is justified and particularly so given the region’s sovereign debt crisis is far from resolved. The euro zone’s monetary authority would be advised to tread very carefully.
charliefell.com
