The latest data confirm a situation of delicate balance between an economy that decelerating, but still relatively robust. Inflation seems to be peaking, but there little sign that the underlying inflationary pressures are abating - but there is also little sign of large second round effects. Looking forward it thus seems appropriate to maintain a relatively tight stance. Monetary conditions are anyway rather tight if one takes into account that the risk premium has increased so that even at unchanged policy rates the interest rates paid by enterprises and households have increased by around 50 bps. The euro has eased a little over the last week, but remains much higher than a year ago. The deceleration in mortgage lending points to a welcoming cooling of the housing sector (obviously with large differences across countries), but on average there is no sign of an euro area wide crash.
The outlook is becoming ever more difficult, with weaker growth and higher inflation. In this situation, unless there is a strong reason to believe that the level of near term inflation is of any significance, the policy stance should remain the same; rates on hold with a clear language cautioning against second round effects. In fact, there is very little that the central bank can do about near term inflation, and inflation expectations are not really reacting to oil prices, nor are wages. Thus, rates on hold for a while, even if near term inflation remains high.
The more we go, the cloudier is the outlook. The provisional data for the first quarter are very surprising, probably because they are provisional. If there is any truth in them, then it would mean that, so far, the reaction to the financial crisis has been milder than I feared. With the bad inflation outcome, this would argue in favor of raising the interest rate. But it is far too early to declare victory and do so.
I am thinking about changing my recommendation to unchanged rates (previously I favoured a rate cut). Growth in the first quarter came out stronger than I expected and inflation was much higher on the back of surging oil prices. Although I continue to expect growth to slow and inflation eventually to come back on weaker commodity prices I see the risk that the present combination of good growth and high inflation could unmoore inflation expectations if interest rates were cut now. Leaving rates unchanged for longer than I previously thought appropriate is likely to exaccerbate the upcoing economic slowdown. But this price probably needs to be paid to avoid that present high levels of inflation become engrained by a rise in inflation expectations.
In principle, there is no trade off, since economic theory and experience typically imply that the expected slowdown in activity will pull core and headline inflation down within the next couple of years or so. But the current situation and recent experience raise doubts about such received wisdom. First, pressures on headline inflation have mounted very rapidly with an obvious risk of indirect and second round effects. Second, in the latest downturn, headline inflation did not fall much. This was despite very low growth in unit labour costs. Now, the downturn would start with larger inflationary pressures on non-core prices and likely higher growth in unit labour costs. This may mean that rates will have to remain unchanged for longer, even as the slowdown starts to become visible.
Compared to last month, the balance of the risks seems to have moved towards inflation. Hence the case of a rate cut has weakened, although second-round effects have not appeared.
Higher commodity prices provide a strong justification for caution on rates. Although the source of higher inflation is the emerging markets, the ECB's mandate means these pressures cannot be ignored to the extent that they affect pricing in Europe. The cost, however, is likely to be lower growth. Monetary policy will have to work to restrain domestic wages and profits to offset higher raw material costs. As such, the room for rate cuts is shrinking fast.
Despite the surprisingly positive data for in the first quarter there should be no doubt that growth will be rather moderate in the remaining part of the year. Inflation should also slow down somewhat in coming months but will clearly stay above the ECB`s target value. So for the time being the best strategy is to keep interest rates on hold. In the later course of the year I still think a rate cut will be appropriate; however, for this step we need convincing signals that inflation is coming down.
The economy is slowing (aside from the statistical quirks in Germany in 1Q) and credit restrictions are not easing (and will not anytime soon). Inflation should drop to target next year (assuming that oil is in a bubble at the moment and will correct at some point). As expected, processed foods are already cooling down.
Central bank support is the only way to avoid the deepening downward adjustment taking place in the euro area in recent months. Current economic indicators signal a contraction of Q2 GDP in most of the area's economies and very weak growth for following quarters, suggesting very difficult conditions for the rest of this year and next. Our forecasts, revised upward in the wake of Q108 figures, continue to point to a sharp weakening in GDP growth to around 1% y/y next year. Consumers'outlook has darkened considerably under the strains of surging commodity prices and tightening lending conditions. Consumption is likely to contract in Q2 after a short revival in Q1. This would be the second contraction in three quarters. Companies are under increasing pressures on their margins and the outlook on activity and profits has also worsened considerably in most recent months. Banks are still under tight liquidity conditions which are restraining considerably their lending conditions. Overall the growth outlook is facing a significant deterioration that is beginning to hurt the outlook for labour markets as shown by recent surveys. Inflation is certainly on the rise and prospects for an easing later this year are much more uncertain now than was the case several months ago. But at this point of the economic cycle, higher inflation implies a worsening economic situation. Real wages are falling into negative territory and conditions are not in place for lower savings. Domestic demand is not responsible for higher inflation nor is credit growth. Hence, the central bank has leeway to ease monetary policy and limit the economic shock from surging commodity prices. Accepting economic weaknness in the euro area will not resolve the problem of inflation as this one results from external demand. Easing monetary policy to limit the downward shock will not either increase the inflation risk given the domestic situation. Although it is certainly not time to recommend loose monetary policy, there is room for a less restrictive monetary policy to soften the downward adjustment.