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The ECB’s stated policy objective is price stability, which is defined as inflation being “close to, but below 2% over the medium term.” Last month, CPI (or more precisely HCIP) moved up from 1.8% to 2% year-on-year. Does this mean that the ECB will now be reconsidering its decision, taken only in December last year, to extend its asset purchase programme for a further nine months to December this year, albeit at the reduced rate of €60 billion, rather than €80 billion per month? The answer is almost certainly not.
Despite CPI being the ECB’s official quantitative measure of inflation, the key wording in the central bank’s policy statement is “over the medium term”. Last month’s increase in CPI was caused mostly by a surge in energy prices, whose rate of increase moved up from 8.1% to 9.2% year-on-year. This large increase is on account of the sharp year-on-year rise in oil prices. For example, Brent Crude rose over 57% in euro terms between the end of February 2016 and the end of February 2017. Furthermore, food prices have been pushed higher by the recent extraordinarily cold weather in southern Europe.
It seems unlikely, with core eurozone inflation running at a mere 0.9%, that Mario Draghi and colleagues will be panicked by what appears to be a temporary, energy and food-driven spike in the headline inflation rate. Unfortunately, this will not go down well in Germany, where CPI is already 2.2% and where an increasingly nervous electorate may well have to wait until its local rate is considerably higher, before the eurozone aggregate rate itself has peaked. If all goes well, at that point Draghi will turn, vindicated, to the markets and declare that the above-target headline rate was a short-term blip and that he was right all along.
Therefore, the best scenario is that the oil price moves no higher and Germany goes to the polls in September worrying less and less about inflation, as the big year-on-year moves fall out of the price index. The worst would be if oil resumed its sharp rise, or if the rising cost of living translated into higher wage demands.
‘Looking through’ short-term inflation is something the Bank of England has done on a couple of occasions. In September 2008 and again in September 2011, UK CPI was allowed to rise to 5.2% and interest rates were subsequently cut or left alone. Indeed, with inflation on the rise as a result of sterling’s post-referendum decline, the Bank of England appears poised to look through above-target price increases yet again. The British attitude to inflation is very different from Germany’s, however. CPI’s running temporarily at 3% over target in the UK might be viewed as a necessary evil. In Germany, such a scenario would prove politically unacceptable.
Draghi is therefore likely to face something of a grilling at the press conference after the ECB meeting tomorrow. He will no doubt carefully explain to the press the short-term nature of the current inflation ‘blip’, making much of the benign core inflation rate of 0.9%. Germany, represented by Bundesbank head Jens Weidmann, will again have called at the policy meeting for a move to rate normalisation but Draghi will have had none of it.
Part of the problem is that, assisted by a weak currency, Germany’s export machine continues to post record surpluses which act to supress demand elsewhere and widen the gap between the winners and losers of the eurozone. Many commentators have suggested that the solution is to encourage more spending in Germany. However, the German consumer remains resolutely frugal. Meanwhile, increased public expenditure on infrastructure, although beneficial in the short term, would in the medium to long term, make the country even more efficient and prone to current account surpluses. Quite apart from that, the multiplier effects of infrastructure spending, whether funded by taxation or (heaven forfend) debt, would be inflationary - and the equivalent of dousing a bonfire with petrol. Unfortunately, it seems the only real solution is a stronger currency, which is of course, impossible within the euro.
Whatever the outcome of tomorrow’s ECB meeting – and I strongly expect there to be no change – the ECB’s one-size-fits-all monetary policy will continue to cause imbalances between the northern and southern eurozone. The latest Greek funding crisis must be resolved before July, but this is a sideshow. It is Germany, suffering from too weak a currency – and increasingly negative real interest rates at a time of healthy growth – which will dictate the economic course of the eurozone.
All views expressed here are the author’s own and are based on information available at the time of writing.
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