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12:55 2007/11/02
ECB ??“ caught between rising inflation fears and persisting growth risks
- Governing Council meeting. Next Thursday, the ECB will leave its refi rate unchanged at 4% and indicate a wait-and-see stance from here on out. Its hands are tied well into next year. At that point, however, the bank will resume its tightening cycle.
- Inflation. Inflation risks are mounting. At the turn of the year, EMU-wide inflation should even head towards 3% and will not return into the target zone over the next 12 months. Furthermore, core inflation is also tending higher (pages 3-4 & chart below).
- Growth. At the same time, however, growth risks remain skewed to the downside. The business climate has already taken a turn for the worse, and consumers will probably exercise greater restraint. After a strong summer quarter, the EMU should enter a soft patch until spring 2008.
- Bank of England. In the United Kingdom, the drag on the economy from the financial market turbulence will be much stronger. But inflation risks are smaller than in the eurozone. That will give the Bank of England scope to lower the key interest rate ??“ possibly as soon as next Thursday (pages 5-6).
Further topics: - Weekly Comment: The inflation ghost is back (page 2).
- US: Fed eases, but reverts to neutral policy outlook (page 9).
- Germany: The upswing on the labor market continues (page 7).
- Data outlook: Weak industrial production in Europe; US purchasing managers becoming more cautious (page 12).
- Market outlook: New highs in EUR-USD; Bunds resisting inflation risks (p. 20).
Inflation ??“ Genie out of the bottle again? Inflation seems to be rearing its ugly head again, making central bankers quite uncomfortable. Up until the very eve of the recent financial market turmoil, central bankers had been warning about inflation risks, in some cases defying the markets??™ skepticism. The Fed kept up its anti-inflation rhetoric in the first half of the year while markets were much more worried about the growth impact of the housing downturn ??“ investors expected rate cuts, but the Fed insisted that it was not yet convinced that the decline in inflation could be sustained. It was only in June that markets capitulated and priced out rate cuts??“ ironically just before the onset of the turmoil would bring them about.
In Europe, although CPI remained reasonable well-behaved, the ECB kept warning about inflation risks emanating from the fast growth of money and credit aggregates, high resource utilization, and potential wage pressures. The ECB had already clearly signaled its intention to hike again in September, and markets were already primed for the refi rate to climb all the way to 4.50% or more.
Even as they altered the course of monetary policy in response to the crisis, ECB council members were careful to signal that they remained committed to containing inflation. The Fed signaled it felt more comfortable that the decline in inflation could prove durable, but still indicated it would keep a watchful eye on price developments.
The risk was obvious: if the monetary intervention was successful in stemming the risk of a significant slowdown in activity, then with growth still humming along healthily, and more liquidity pumped into the system, inflation risks might quickly increase and become the center of attention for both investors and consumers. Indeed, the first Fed rate cut in September triggered some increase in inflation expectations, as the market started pricing a shift in the Fed??™s relative preference for growth versus inflation.
Price developments over the last couple of months have not been forgiving. Inflation in the eurozone just spiked to a higher-than-expected 2.6% y-o-y (October??™s flash estimate), following a jump to 3.6% in Spanish inflation. The rise in eurozone inflation is partly explained by base effects on energy, but these have been compounded by the recent surge in food prices. The question of whether or to what extent the rise in energy and food prices will be sustained and could therefore end up feeding into core inflation has become increasingly important. In a recent speech, Fed Governor Mishkin highlighted the risk that sustained shocks to noncore prices can shock inflation expectations and feed back into core inflation, and made explicit reference to the recent rise in energy prices as a potential risk. The reference was repeated in the FOMC statement of two days ago. The risk is clear. Increases in energy and food prices are quickly perceived by consumers, and receive a loud echo in the media??” if they go on for much longer, the risk that they would bias consumers??™ perceptions of overall inflation would be significant. Moreover, in the US we face the additional risk that the substantial compression in refineries??™ margins to date will be partially reversed, which would cause a significant increase in prices at the pump (see our latest Commodity Outlook).
The Fed seems to have decided that the danger is real enough that the bank needed to refocus attention on the inflation risk (cf. Research Note by Roger Kubarych). The apparent easing of financial markets strain and the robust improvement in investor sentiment especially on equity markets provided a precious opportunity to cool down expectations of further rate cuts ??“ while signaling confidence in the outlook ??“ and therefore expectations of inflation. The relatively tougher tone of the FOMC statement will in turn give heart to the hawks on the ECB council, who must already be looking for the next opportunity to resume the tightening cycle (cf. Research Note by Aurelio Maccario).
In our view, however, risks in the US are less balanced than the FOMC statement indicates, with significant uncertainty on the extent of losses in the financial sector mirrored by the vulnerability of private consumption. Our outlook remains sanguine, and based on our central scenario the Fed would not need any further rate cuts, but we see the risks to growth squarely biased to the downside. Overall, risks to growth and to inflation have both increased, leaving central banks caught between a rock and a hard place. Dealing with the blow-up of the credit turmoil has been nerve-wrecking, but the central banks??™ job might be getting even more difficult.
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