The latest numbers on inflation confirm that it is not a foregone conclusion that there will be no second round effects and that the surge in consumer prices will remain limited to energy and food. The available forecasts for inflation are still close to the 2 % target, but experience suggests that actual inflation will be about half a percentage point higher. Hence there is not reason to cut rates looking only a price stability. Economic activity in the euro area is slowing, but not collapsing, hence there is no urgent reason to cut rates to stimulate economic activity. Real (ex post) rates of interest are anyway still below any estimate of the natural rate. Financial markets are still nervous, but it is difficult to argue that financial markets are on the bring of breaking down when the biggest IPO ever in the financial sector has just been announced
In the past, we have observed the transmission of US slowdowns to Europe with some delay, defeating optimistic views about decoupling, and raising issues on what exactly explains this pattern: quasi simultaneous shocks? Financial and trade spillovers? At this stage, the news from overseas is becoming clearer, on the negative side. At the same time, the price pressure from commodities and food raises the need of a non-inflationary adjustment in the relative prices of consumption goods but also of productive inputs. The main question is how sticky inflation will be in response to the current round of price changes. At this stage, I still see the current rate as appropriate. However, the delay in addressing the financial root of the crisis is clearly creating cumulative damage. The idea (and the hope) that rates cut could be a substitute for unveiling the investment positions and cleaning up the balance sheet is simply wrong. Gradualism and caution does not exclude a strong initiative at international level to facilitate the transition from the current regime of wait and see to a regime of pro-active portfolio rebalancing – an initiative that, in the euro area, cannot be promoted by the central bank. The publication of last year results by financial institutions could provide the opportunity for managing the crisis in more radical ways.
Given the latest economic figures from the business surveys it appears that the economy in the euro area is still robust though there are clear signs of a cyclical weakening. In this environment there is no need for emergency measures and the ECB can wait for another month or two before taking an interest rate decision.
The present situation is very confusing with rising inflation and declining growth prospects. However I still see an asymmetry between both risks: although present inflation is high, the revisions of growth forecasts are impressive. Because these revisions are demand-driven, I am not so much worried about future developments of inflation which should be at the center of the monetary decision.
GDP growth moderated to a below-trend pace in 4Q and surveys suggest that a similar or lower pace of expansion is continuing early this year. Exports are slowing as exepcted but, more importantly, consumer spending is weakening further, following a disappointing performance of previous quarters. Deteriorating labor market prospects (as already perceived by households) and the ongoing tightening of lending standards reduces the chances of a rebound of consumer spending anytime soon. As a result, prospects for GDP growth have been revised down, and risks to growth remain on the downside.
The uncertainty about the near-term inflation outlook has increased as a result of the protracted increase in food prices. However, inflation expectations remains reasonably contained, implying that the main impact of higher food prices will be to limit real disposable income and spending. As a result, the medium-term inflation outlook remains benign: There are no signs of a broad-based wage acceleration and firms’ pricing power is diminshing thanks to sluggish consumption. All in all, the probability of a below-2% inflation rate in 2009 remains high (assuming a normalization of food prices.)
Despite the partial normalization of money-market spreads, financial conditions are not easing (and probably are more restrctive.) Corporate bond spreads continue to widen (especially for lower-grade paper) and bank lending surveys suggest that the widening also will happen for bank lending rates. Thus, despite the still-high current inflation rate, the downside risks to growth are becoming more prevalent.
I find the present discussion about moral hazard very muddled. Faulty regulation, bad supervision, and careless behaviour of investors played a key role in the development of the credit bubble. But the only party I presently see getting away scot free are the regulators, central bankers and politicians who have been responsible for faulty regulation and bad supervision. Investors are learning their lesson already, with bank stocks down 30% since last May (S&P500 financials) and the Itraxx crossover up 220% on the year, and workers are losing their jobs (US unempoyment is already rising and I expect Europe to follow within a year or two). Do those warning of moral hazard have a target for the decline in financal stocks and widening of credit default spreads when they argue against monetary policy easing on this ground now?
I expect growth now to slow to 1.3% this year. As a result of this, inflation is likely to come down to 1.8% in 2009. Despite the expected slow-down of growth and resulting decline in inflation, monetary conditions are very tight.Financial market volatility has increased and risk aversion seems on the rise (see the surge in credit default swap spreads). Hence, both economic and financial analysis points to the need for lower ECB rates to counter downside economic risks. Since we are dealing here with a financial shock, we would fall behind the curve if we wait until real economy indicators point confirm the downturn.
I think that the case for a cut has become stronger. I share the widespread (including the ECB's) concerns about inflation. The recent wage deal in Germany only added to these concerns. But I think that the risk of credit rationing is more pressing than inflation risk at the moment. As we saw in Germany in 2002-04, credit rationing can have a very negative impact on activity. I have to admit that I am not sure that cutting rates would be enough to avoid credit rationing - or the ECB would need to cut them by much more than the inflation outlook allows. But I disagree with the idea that a rate cut would raise moral hazard. The issues that have arisen around the securitisation market show that regulation has been inappropriate and probably needs to be changed. But regulatory changes are the right tool to fix this issue, not policy rates.
A wait and see stance is probably appropriate at this stage with a readiness to ease should the economy display additional weakness. The RBS/NTC flash PMI for February was stronger than I had anticipated and seems to indicate that the weakness that had built up at the end of January did not continue into February. However, the composition of the survey indicates that the trend in activity is most likely to remain down in the coming months with manufacturing leading the way, on the back of weaker export orders. Activity in the services sector rebounded somewhat in February from close to stagnation but remains subdued and weaker than in Q3 or Q4 last year. Overall, this suggests that Q1 GDP growth will be weaker than Q4, which was slightly stronger than I had anticipated, but both should be below potential. Overall, while activity seems to be on a slowing trend, the pace of slowdown appears somewhat weaker than some indicators suggested in January.
On the inflation front, I continue to see an annual average well above 2%, around 2.7%, with no indication that headline inflation will go back below the 2% level at any point during 2008. While most of these elavated inflation numbers are the result of high food and energy inflation, a clear sign of a peak in inflation is yet to be confirmed.
Additional economic weakness and signs that inflation will indeed decline significantly towards the end of the year and beginning of next are necessary for me to vote for an ease.
I'm not sure that the decision to cut rates has become any stronger but, then again, I thought the case was strong enough last month. I agree with Julian that inflation is uncomfortably high and accept that commodity prices are certainly elevated. But I'm more worried about the reversal of securitisation and my sense that this is a problem for the eurozone as well as the US and the UK. As Charles says, the information is opaque but I suspect that many of the investors who bought asset backed securities and who are now sitting on large losses were based in Europe. The same holds true of the banks. I expect this to lead to a sizeable restriction of lending in coming months (and, for that matter, a sizeable increase in cash hoarding as banks worry about the impact on their balance sheets of contingent credit lines offered in more liquid times to companies). Thus there may be an undesirable tightening of monetary conditions for a given level of official interest rates. I would hope that inflationary pressures would then slowly dissipate. There is, after all, no automatic connnection between commodity prices and inflation, otherwise Japan, a major commodity importer, would presumably be in big inflationary trouble.
I find the forecasts utterly confusing. Inflation is high, maybe higher that we thought and expected to decline. Output is slowing down, may be less badly than we could fear last month. This makes the case for an interest rate reduction a bit less compelling than I thought last month it would be by now. I would like to wait for more indicators to finalize my recommendation.
I am also concerned by the evidence of trouble in European banks. This, to me, is an argument for no cut. It has now been nearly seven months since the subprime crisis started, and banks are still providing very partial information about their actual and potential losses. Not only are many banks surprisingly opaque (what do the supervisors know? what do they tell the ECB? why are they not pressing banks more forcefully to come clean?) but, drop by drop, they make the situation worse as if they were trying to push the ECB to lower its rate. Moral hazard is growing and growing.
The inflation situation has not become so much clearer that I am yet ready to sanction an ease. As you know I've been warning of inflation risks for a long time and while I think there will have to be an ease at some stage, I think easing while commodity price pressures are so strong is not the best timing.