With CPI inflation now at 3.7 percent and the real economy still strong despite slowing down a bit (and despite the likelihood that it may slow down quite a bit more in the future), the risk that inflation expectations of wage and price setters will get embedded at a level well above the target level is high. Higher rates will help slow down demand and may also have some direct effect on inflation expectations, precisely because it would be a costly signal.
The ECB has taken the bold decision to raise rates imminently despite signs that economic activity in the euro area has lost considerable momentum. The decision reflects a change in the assessment made by the central bank on the duration of the commodity price shock and its implication for inflation expectations. With the shock turning out to be more long lasting than expected, the ECB is reponding to a sustained decline in the real rate of interest rate as it might be judged to have become too expansionary. Too low real rates in the 1970s' were blamed as the main policy mistake that fuelled higher inflation, a mistake the ECB wants to avoid at any cost. The stickiness in real wages through implicit or explicit nominal wage indexation mechanisms and the tightness in labour markets has become the number one issue of the central bank. The first response is thus to ensure that wage setters do not readjust their inflation expectations upward in a backward looking fashion. Should this fail and real wage growth prove sticky, the central bank will be forced to raise rates further. In the long term however, should the supply shock prove to be permanent, potential output growth will decline and and the central bank should in theory need to adjust its policy rate downward to take into consideration the decline in the real neutral rate. The strategy adopted by the ECB is a risky one in a context of slowing activity and as inflation expectations are currently driven off commodity prices and are thus likely to prove unresponsive to a policy tightening. This risks forcing the ECB to deliver too much policy tightening.
I tend toward voting for no change. A single rate hike, followed by nothing later on, makes no sense. Either the ECB jacks up its rate to around 5%, which will make a difference, or it stays put. The argument for staying put is that most forecasts indicate that inflation will decline back to the safe zone within 4 to 6 months, as the economy further slows down. If that is so, there is no point in hurting the subsequent recovery, which is what raising the interest rate now would do. A good reason to raise the interest rate is to stunt second round effects, but those that are not found in most forecasts. I would like those who advocate raising the interest rate to indicate why they do not believe hwat most of the inflation forecasts tell us and alos, how far they intend to raise the interest rate over which horizon. I may be convinced, but I need to see solid arguments.
Notwithstanding stronger than expected first quarter growth, I see clear signs that the economy is slowing in the course of the coming 12 months. In this environment, any wage increases will depress profit margins, inducing companies to cut investment and jobs. As demand growth eases inflation ex food and energy will remain well contained. The outlook for food and energy prices remains uncertain (though I would expect prices in 12 months time more likely to be below present levels than above). But whatever happens to these prices, I believe it is a bad idea to force core inflation to a level so that the headline inflation target can be achieved on a 12-18 months horizon. Such a monetary policy generates economic instability, a sin correctly criticised by the monetarists in the 1970s. Moreover, I do not see the need for a rate hike now to bring inflation expectations down. The latter will fall when the economy weakens, and this does in my view not require an extra push by monetary policy. In fact, I think that a rate hike now carries considerable risk. Financial markets remain very unsettled, and it is in my view a bad idea to rattle them further with a rate hike that is very controversial among economists (and apparently even within the ECB Council). In fact, hiking rates now raises the risk that cuts will be needed again in due course.
The ECB remains confronted with a major "supply-shock" in the form of a jump in energy prices, which is simultaneously boosting inflation and lowering GDP growth. Unless there are permanent effects on inflation, the standard response should be to maintain policy rates unchanged, particularly if, as is the case of the euro area, they are roughly in line with the neutral level. Thus, the advise should be to keep policy unchanged.
Given the possible lagged effects of both the commodity price jump and the 2005-07 monetary tightening (exacerbated by the financial crises since last summer), there exist respectively upside risks to inflation and downside risks to GDP growth for the coming quarters. If any of these risks looked as materializing, there is a case for a (moderate) monetary response. In my view, there is no compelling reason to assume that any of these risk-scenarios are developing at the moment:
On the inflation front, wage growth remains contained (notwithstanding a modest acceleration this year) and the incipient deterioration of labor market conditions renders another acceleration next year unlikely. Although perceived inflation is currently high, there is no evidence of an increase in long-term inflation expectations (in fact, the near-stagnation of consumption over the past three quarters suggests that households are reacting to food-and-energy inflation by adjusting spending - an indirect evidence of an absence of an inflation psychology. All in all, ex-food-and-energy inflation remains stable around 1.5 to 1.75 %.
On the GDP growth front, the 0.8% Q/Q gain in 1Q likely was exaggerated by temporary/statistical factors, and a significant correction (probably a negative print) is likely in 2Q. Most monthly indicators suggest that the economy expanded at a subpar pace of about 1.25% (annualized) in 1H. A period of sub-trend growth is the price to pay for digesting the adverse terms-of-trade shock, and to raise the probability of no "second-round" effects on inflation. However, business surveys and PMIs for June indicated further economic weakness entering into the summer, and another downgrading of the expansion (with rates of GDP growth barely above zero) is quite possible in 2H. Thus, while a rate cut is probably premature, because growth has not slowed dramatically yet, the risks to the downside may be intensifying, and a rate hike would compound those risks unnecessarily.
There are clear signs that the business cycle in the euro area is turning down. Also in Germany where the current level of economic activity is still relatively high, the economic outlook for the second half of the year has deteriorated significantly according to the latest ifo business survey. On the other hand, core inflation in the euro area is stable and there are signs that it is slowing down within the next 12 months. The latest increase in headline inflation is exclusively due to energy- und food-prices, which cannot be influenced by monetary policy. Second round effects are in this environment of cyclical weakening of the economy not very likely. In conclusion there is no convincing argument to hike interest rates now. On the contrary, without the special effects from the energy side which justify a more cautious policy stance, even a decline of interest rates would be advisable. Thus, I vote for stable interest rates at the forthcoming meeting.
The first question is whether inflation expectations have risen. With only poor measures of expectations available, we do not really know. But the three sets of information (wage settlements, break-even inflation rates and business and consumer surveys) all point upwards. Moreover, inflation was slightly above 2% in the past, within a relatively favourable world environment for inflation. Now that there seems to be a consensus that food and energy price increases will generally be higher than in the past, possibly significantly so, it would probably be justified for inflation expectations for the short to medium term to move up. So there could be a justification to raise rates in order to make it clear to price and wage setters that the ECB is committed to achieve its objective. However, I still do not think it is advisable for the ECB to raise rates now because the slowdown in growth has only started and will probably deepen and last for several quarters, thereby bringing relief on the wages side. Eventually though, if the environment of higher (increases in) food and energy prices is here to stay, it would make sense to review the objective. This is not feasible at the moment, when inflation is so much above 2%. But in time, if some structural changes such as these seem to have happen, a review of the objective seems warranted.
The most disturbing feature of recent developments is the deteriorating trade-off between growth and inflation. I've argued before that the source of inflation is, ultimately, overly-loose monetary conditions within the emerging markets. Their failure to act, though, means the ECB must, if only to insulate the eurozone from monetary mistakes being made elsewhere.
Central banks have to demonstrate to the public at large that they're not willing to tolerate sustained deviations of inflation from target, whatever the source of inflation. Failure to do so could easily lead to a meaningful rise in inflationary expectations. The cost of action is likely to be a temporary loss of output, but that would be better than a permanent rise in inflation.