What to make of Axel Weber's comments on inflation?

By: Eurointelligence ECB Watch

 

The financial markets have not taken much note of recent comments by Germany's two most senior central bankers, Axel Weber, president of the Bundesbank, and Jurgen Stark, head of monetary policy in the ECB, and a member of its governing council. Both warned about inflationary risks, and both did not rule out interest rate increases in due course.

 

We take these comments seriously. A view seems to be gaining ground within the ECB that interprets the temporary lull in the credit crisis as a signal that the worst is over. We believe that this crisis is profound, that it will take several years to clear up, and that it will affect the world economy significantly through a variety of channels. But as this crisis is not going to promulgate in a linear way, it is to be expected that this view is going to be challenged during long periods. One such period is now. The ECB seems to be converging towards a view that the economic consequences of this crisis are containable, and that we are slowly returning to a normal position.

 

In view of this expectation, it would seem plausible for the ECB to raise interest rates. At this stage we stick with our forecast of a 4% repo until the spring, but we have to acknowledge that there is a non-trivial risk of a rate increase during the winter.

 

In his interview with Frankfurter Allgemeine, Weber made the point the change in inflationary expectations had occurred very recently. Now oil is always a source of inflation, and its price has recently gone up, but one would have thought that the impact of a higher oil is largely corrected for by the rise in the euro. In fact, the rise in the euro is not a policy dilemma at all, as some economists keep on insisting. It is makes policy a lot easier. It allows the ECB to sit tight for the time being.

 

So what else did produce change in the last few weeks? Our interpretation is that Weber's remarks are geared largely for domestic consumption. What concerns the Bundesbank is a gradual realisation that the end of wage moderation in Germany has arrived, as evidenced by the train drivers' strike in favour of a big double-digit wage rise. We are likely to see big rise also in next year's wage round. The Bundesbank may also react to the end of the government's reform strategy, after the leftward shift in the SPD. The Bundesbank probably takes the view that an end to the reform process means a downward revision of future productivity growth estimates. In that case, a higher level of interest rates may indeed be warranted.

 

It is our reading that there is at present no sufficient majority within the ECB's governing council to raise rates. Just imagine the political consequences, especially in relations with France, where the Elysee is loudly calling for a cut in rates. The euro's exchange rate with the dollar would probably break through $1.50, the German finance minister would say that he loves a strong euro more than ever, and we are going to see a really nasty political fight between France and the ECB, and between France and Germany. Our inclination is that the ECB will want to avoid such a confrontation, especially as long as there is an incalculable risk that its positive expectations may be mistaken. But we should not underestimate the importance of Germany's two most senior central bankers pushing for higher rates.

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