How worried is the ECB about inflation?

 

"Risks to the outlook for price developments remain on the upside. They continue to include the possibility of further increases in the prices of oil and agricultural products as well as additional increases in administered prices and indirect taxes beyond those announced thus far. Taking into account the existence of capacity constraints, the favourable momentum of real GDP growth observed over the past few quarters and the positive signs from labour markets, stronger than currently expected wage developments may occur, and an increase in the pricing power in market segments with low competition could materialise. Such developments would pose upward risks to price stability."

 

Jean-Claude Trichet, ECB President, about inflation risks:

 

 

 

 

It is characteristic of the ECB, and unlike the Fed, that it does not immediately change its mind, when the facts have changed. If in doubt, it worries about inflation in public, but this should not detract us from our analysis that, in the euro area at least, the downside growth rise are higher than the upside inflation risks, despite all those factors that Mr Trichet has mentioned in his introductory statement on Thursday. Yes, there is always the possibility of oil and food price shocks, though that either price could shocks by going down. There are of course capacity constraints, and to the extent that it matters for the rest of us, the German rail strike is probably the clearest signal yet that the age of the grand wage moderation is finally over. If you want to worry about inflation, you can. Reading Mr Trichet would be a good start to a day of hyperventilation.

 

But then again, the strong euro provides a useful buffer, as indeed has been the rise in Euribor market rates. A 3-month Euribor of 4.8% would otherwise be consistent with three further quarter point rate increases, plus some residual specultion of a 5 per cent interest rate at some stage in the future. Also, the latest lending surveys show us that the credit squeeze has led to a tightening in credit conditions. As the various confidence indicators, such as Ifo, are pointing towards a fall in economic activity, we do not actually agree with their majority of analysts that the ECB was facing some kind of dilemma. In terms of decision-making, the ECB had a relatively easy day on Thursday. It was clear that it would neither raise nor cut rates. So much monetary tightening has occurred quite naturally during the last couple of months that the ECB can leave interest rates unchanged without incurring any additional risks to price stability. From the narrow perspective of the ECB, the crisis and the revaluation of the euro came at just the right time.

 

Central banks, and especially the ECB, do not like to signal too many shifts at the same time. If the ECB worried about inflation two months ago, it will not tell us that the problem is over, while policy appears unchanged. We therefore treat the introductory statement with a grain of salt. We certainly do not believe that there is any meaningful risk that policy interest rates would go up in the next few months. Mr Trichet did not use the word "vigilant" because he isn't, not because of any deep change in the way the ECB communicates from now on.

 

The next rate move will be downwards, as the impact of the credit crisis on the European economy will become apparent, via the exchange rate, trade, and financial market effects. We know that the ECB is fast in reacting to changes in inflation, but slow to changes in economic growth. So the ECB will at best offer an imperfect cushion during the next downturn. It will argue, rightly, that fiscal policy is too lose given the late stage of the economic cycle, and that finance ministers should have set themselves a more ambitious schedule for deficit reduction during good times.

 

It will, however, take some time for this to become so apparent that even the hawks on the governing council would buy into this story. Until then, the ECB will pretend to remain concerned about inflation, until the moment when the risks are pointing the other way - very evidently, and for everybody to see. When the economy turns down, capacity constraints will gradually cease to be a problem. There is a problem with the 2008 wage round, as the European labour market has a tendency to reach backward-looking wage-settlements. There is a risk of excessive wage agreement in some sectors, but there is also a changes that this would come at the expense of profits, rather than prices.

We are confident in reiterating Stephen Jen's forecast in respect of the US, also in relation to the euro area. We might get a fall in growth, or a rise in inflation, but we are until get both at the same time. This does not necessary mean that this recession will be easily contained. It may, or it may not be. But it means that policy can, and will, eventually react.

Unlike ourselves, the ECB does not take a bet on this or the other outcome, and remains mindful of all the dangers that it might possibly have to confront until the picture becomes clearer. If and when the threat to growth outweighs the threat to inflation - we expect that to become clear during the early winter - the ECB will have to think about new ways to signal the next rate cut, something like strong vigilence, someting like "excessively complacent". We continue to believe that the global economic downturn will be quite severe, tempered only in part by a continued strength, in some though not all emerging markets. The central banks will this time not come to the rescue.

 

 

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