ECB Remains Focused on Inflation
Led by rising prices for food and energy, euro zone inflation is at the highest level since the start of the European Monetary Union. And the central bank is detecting the first signs that inflation expectations are creeping higher as a result, raising the specter of second-round effects. As long as the European Central Bank remains cautiously optimistic on growth, inflation risk will leave central bankers resistant to rate cuts.
The latest report on a leading euro zone inflation benchmark shows why policymakers are on guard. Euro zone February HICP (Harmonized Index of Consumer Prices) inflation was unexpectedly revised higher to 3.3% year over year, up from 3.2% year over year reported previously, and vs. just 2.1% last September.
The sharp acceleration since September is due mainly to a combination of base effects from higher energy prices and a pickup in food prices on international markets. Data showed annual food price inflation jumping to 5.8% year over year from 5.4% year over year in January, and just 2% year over year in July last year. This was the highest level recorded since the start of the series in 1999.
Asian Growth Boosting Demand for Food
The main pressure comes from processed food prices, which were up 6.5% year over year in February, vs. gains in volatile unprocessed food prices. The ECB, in a recent monthly report, points out that the pickup is the reflection of a sharp increase in prices on world markets since the middle of last year. Adverse weather conditions are partly to blame. But while these should have only a temporary impact, there are also other more lasting factors.
Strong economic growth and changing consumption patterns in Asia have boosted international demand for foodstuffs, including milk and milk products. Furthermore there has been a sharp increase in demand for some agricultural commodities, for example for the production of biofuels. As the ECB points out, these are structural factors, likely to exert more persistent upward pressure on global food prices in the future.
Processed food accounts for nearly 12% of the basket used to compute HICP inflation, and the sharp increase in February contributed almost 0.8% points to overall annual inflation. Initially the ECB hoped that food price inflation would start to fall back toward its long term average this year, but it now admits that this won't happen as quickly as hoped for.
Calling for a Common Agricultural Policy Review
Indeed, there is the risk that there will be further upside pressures from strong international demand, as supply is relatively inelastic in the short run, and production may only react with a considerable time lag to the change in the market. The ECB, in its December report, already suggests a review of the EU's Common Agricultural Policy (CAP), which regulates and restricts supply in certain areas.
The ECB in its March monthly report also looks at measures of underlying inflation and stresses that there is a general rise in these indicators that needs to be monitored carefully. The ECB already has changed its central inflation scenario with the latest set of economic forecasts and is now predicting average inflation of around 2.9% this year and 2.1% year over year in 2009. This means that inflation is expected to fall back below the ECB's upper limit for price stability of 2% over the forecast horizon. The ECB continues to stress that the risks to inflation remain on the upside.
Apart from further increases in oil and agricultural prices, these risks "include the possibility that stronger than currently expected wage growth may emerge, taking into account high capacity utilization and tight labor market conditions…Moreover, the pricing power of firms—notably in market segments with low competition—could be stronger than expected."
Consumer Inflation Expectations Rising
Producer price inflation has accelerated to 4.9% year over year in January, from 4.3% year over year in December. This was not only due to increases in energy and food prices, but also to almost all components. The NTC Purchasing Managers Index for February also showed high input cost pressures in both manufacturing and services, and at least in the manufacturing sector output price indicators also suggest some pass-through effects from higher input prices.
The risk of second-round inflation effects increases if the prolonged inflation overshoot leads to upward revisions to inflation expectations. The ECB's latest Survey of Professional Forecasters already suggests that aggregate point estimates for longer-term inflation expectations have been revised up, to 2% from 1.9% previously.
Survey data from the European Commission also indicates a rise in consumer inflation expectations. The reading for the price assessment in the past 12 months rose to 60 in February, compared with 59 in January and just 36 in July last year. Future price expectations for the next 12 months remained stable at 28 in January, unchanged from December, but up from a reading of 19 in July of last year.
Labor Unions Are Demanding Wage Hikes
The marked rise in consumer price expectations raises the risk of second-round inflation effects via higher wage demands at a time when major wage negotiations are on the agenda. Euro zone labor cost data suggest that so far cost increases have remained moderate. However low overall increases in recent years have, to a large extent, been facilitated by considerable wage restraint in Germany. But after very robust German growth last year, and with local inflation rising sharply also due to last year's value-added tax (VAT) hike, unions are now intent on making up for past sacrifices.
Germany's IG Metall union already has secured a wage rise of around 5.2%, and public sector workers are currently staging strikes to demand pay increases of 8%. As such, it's not surprising that Bundesbank President Axel Weber stresses the risk of second-round inflation effects via higher wage demands. The problem is that the ECB cannot directly influence wage demands, and can only warn against the negative effects of a price-wage spiral.
Slovenia Has Europe's Highest Inflation
Union wage demands are not the only obstacle the ECB has to cope with. Inflation differentials in the euro zone remain quite high, which partly reflects indirect taxes, administered prices, and government budget policies. In Spain, many public-sector wage agreements contain wage indexation clauses.
In Slovenia, the country that posts by far the highest inflation rate, there is both high wage growth and lax fiscal policy. The ECB has warned in the past that Slovenian wages are rising faster than productivity, and that lax fiscal policy could create a "boom and bust cycle" that might ratchet up inflation. Slovenian officials have rejected the claims. As the previous experience with Ireland shows, the ECB's warnings have little impact on countries that are too small to trigger an immediate change in policy when their inflation rates shoot up. However all these factors add to the ECB's inflation worries.
What does this mean for the ECB outlook? Comments from officials since the last meeting confirm that central bankers are still preoccupied with upside risks to inflation, and concerned about a possible unhinging of inflation expectations. At the same time, central bankers stress that while the risks to growth lie on the downside, the economy remains robust. The surprisingly strong results from a Mar. 26 poll conducted by Munich-based research institute Ifo supports the ECB's central scenario that growth will be below but close to potential. Some council members seem more concerned about growth risks than others, but on the whole there does not seem to be a consensus for rate cuts at the moment.
The ECB's Situation is Different From the Fed's
Speculation about coordinated central bank cuts have been rife, with cancellation of planned trips by Christian Noyer and the Bundesbank's Weber to Canada adding to conspiracy theories ahead of the Easter holiday. However ECB officials such as executive board member Lorenzo Bini-Smaghi have been eager to stress that the ECB is in a very different situation than the Fed, and that therefore different policy responses are merited. Mega-hawk Weber also indicated that inflation leaves little room for rate cuts, and an MNI (Market News International) source story suggested that the ECB is more likely to talk about a rate hike than a cut at the next meeting.
There also has been some vague talk about internal discussions within the ECB about the merits of a rate cut, vs. direct intervention to stem the euro's rise. Given the recent strength of the euro and official comments damning "excessive" foreign exchange volatility, this seems to have more merit. So far officials have stuck to verbal intervention.
This is no surprise, as they previously indicated that unilateral intervention would have limited chance of success. There is no sign so far that the ECB would get international backing for a move, even though it is likely that officials will be pushing for at least verbal support from the U.S. to back the dollar and prevent a further appreciation of the euro vs. the dollar.
All in all, we don't see the ECB cutting rates anytime soon, and in our view officials would indeed favor intervention over rate cuts to stem the euro's rise. Markets have already scaled back rate cut expectations somewhat after last week's ECB comments and in light of the strong Ifo numbers, but in our view still remain too optimistic about monetary easing in the euro zone.