Having Tea at the Dovish ECB

Thursday, September 04, 2008

The governing council of the European Central Bank (ECB) seems to have had a very sanguine meeting, leaving the key interest rate as expected unchanged at 4.25% in an unanimous vote.
I am actually blown away by the dovish tone expressed in the introductory statement and the following press conference. 
Not only that the ECB has for the first time failed to mention "being vigilant" - a standard phrase in the past - but now starts to blame wage effects for the surge in inflation it has so far missed to address appropriately with a more decisive rate policy.
Currently the ECB is wide off the mark
Inflation is almost double the target rate of 2% and ECB analysts predict a figure between 3.4% and 3.6% for the full year 2008.
With regard to price developments, annual HICP inflation has remained considerably above the level consistent with price stability since last autumn, standing at 3.8% in August according to Eurostat’s flash estimate, after 4.0% in June and July 2008. This worrying level of inflation is largely the result of both the direct and indirect effects of past surges in energy and food prices at the global level. Moreover, wage growth has been picking up in recent quarters, at a time when labour productivity growth has decelerated, resulting in sharp increases in unit labour costs.
Looking ahead, on the basis of current commodity futures prices, the annual HICP inflation rate is likely to remain well above levels consistent with price stability for quite some time, moderating only gradually during the course of 2009. Consistent with this view, the September ECB staff projections foresee average annual HICP inflation at between 3.4% and 3.6% in 2008, and between 2.3% and 2.9% in 2009. The higher inflation projections for 2008 and 2009 mainly reflect higher energy prices and, to a lesser extent, higher food and services prices than assumed previously.
Money supply points to upside risks for price stability too, the ECB acknowledges. M3 is still running at more than double the target rate of 4.5%.
The monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons. In line with our monetary policy strategy, we take the view that the sustained underlying strength of monetary and credit expansion in the euro area over the past few years has created upside risks to price stability. Over recent quarters, these risks appear to have become manifest as inflation has trended upwards.
Not least in the face of the ongoing tensions in financial markets, the monetary analysis helps to support the necessary medium-term orientation of monetary policy by focusing attention on the upside risks to price stability prevailing at medium to longer horizons. While the growth of broad money and credit aggregates is now showing some signs of moderation, reflecting the policy measures taken since 2005 to address risks to price stability, the strong underlying pace of monetary expansion points to continued upside risks to price stability over the medium term.
The currently flat yield curve has given rise to a substitution from longer maturity assets into monetary instruments, which offer similar remuneration but greater liquidity and less risk. This substitution has led the current headline rate of M3 growth to overstate the underlying pace of monetary expansion.
Remembering the single mandate of the ECB - to hold inflation below 2% and M3 around 4.5% - I would consider the inactivity of the ECB as a dangerous precursor for more inflation down the road. This could soon turn into a "too little, too late" situation where the ECB will be behind the curve.
The hesitancy to give markets a sign of decisive hawkish commitment probably has a political background too. The ECB lowered its staff forecast for growth in the Eurozone:
Taking into account all available information, the euro area economy is currently experiencing an episode of weak activity characterised by high commodity prices weighing on consumer confidence and demand, as well as by dampened investment growth.
This outlook is also reflected in the September 2008 ECB staff macroeconomic projections for the euro area. The exercise projects average annual real GDP growth in a range between 1.1% and 1.7% in 2008, and between 0.6% and 1.8% in 2009.
I am quite confident that a lot of politicians are frequently pounding on the doors of their central banks, fearing a continually worsening of economic growth in case of more hikes that will be unavoidable in the medium term if the ECB wants to retain its credibility an an inflation fighter.
Their fears are unfounded as long as the ECB describes credit availability quite unrestricted:
In particular, the pace, maturity and sectoral composition of borrowing from banks suggest that, at the level of the euro area as a whole, the availability of bank credit has, as yet, not been significantly affected by the ongoing financial tensions.
Eurozone citizens though, plagued by high food inflation, have turned cautious on long term financial commitments as the downtrend in private lending still continues, according to the ECB and also observed in declining retail sales.
The surprisingly complacent impression the ECB left on markets pushed the Euro to a new seven-month low of $1.4333. Oil and gold weakened accordingly, displaying their negative correlation with Federal Reserve Notes.

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