ECONOMICS:With no wage pressures on the horizon, the ECB looks like it's repeating its 2008 over- reaction to price spikes
THE DECISION of the European Central Bank (ECB) last week to signal that it will raise official interest rates next month took almost all observers by surprise. It was a very unwelcome surprise in the zone’s weaker periphery, where an increase in rates will hinder recovery.
It was extremely unwelcome in Ireland. Not only is the recovery weak, but absolute levels of indebtedness are high and the proportion of debt subject to variable interest rates is the highest in the zone. All of this makes the Irish economy the most sensitive to rate changes of any of the 17 single-currency economies.
Frankfurt’s decision ostensibly reflects concerns about rising consumer price inflation in the euro zone. The annual rate of inflation hit 2.4 per cent in February, according to preliminary figures. The ECB’s new inflation forecasts for 2011 range from 2 to 2.6 per cent.
As the ECB’s core mandate is to keep the rate “below but close to 2 per cent”, there is a prima facie case for an earlier start to the rate-rising cycle. But when all indicators are considered, it is not possible to conclude that tightening is warranted in the short term if containing consumer price inflation is the sole concern of the bank.
Consider first the underlying inflationary picture in the euro zone. Statisticians strip out from the headline figures those items whose prices are subject to unusual volatility. This gives a “core” or underlying rate of inflation. This most up to date core rate, which excludes energy prices, remains subdued, standing at just 1.3 per cent in January.
Thus, the uptick in inflation is almost exclusively a result of high energy prices, which have been pushed higher again in recent weeks by concerns about real or potential supply interruptions as a result of political instability in north Africa and the Persian Gulf.
It was thought that recent experience would make the bank wary of over-reacting to big energy price increases. In the summer of 2008, when spiking commodity prices had a similar, if much more marked impact (see chart) on the headline inflation rate, the ECB increased rates. The bank came in for much criticism, particularly as the pre-quake tremors of the financial crisis were being felt and the downside risks to growth were clear. In the ECB’s 12-year existence, it has never been so clearly wrong.
Despite this experience and the smaller inflationary impact of energy prices now, the bank looks set to over-react to price spikes once again.
Another reason to question the bank’s intention to begin tightening is the complete absence of wage pressures which could signal the beginning of what central bankers fear above all else – a wage-price spiral.
Unemployment in the euro zone stood at 9.9 per cent in February. This is only fractionally down on the recessionary peak recorded last year (of 10.1 per cent)) and almost a full percentage point above the peak jobless rate during the last downturn in 2005. It was in the mid-1990s that joblessness last stood at the sort of levels at which it has been stuck for the past year.
Given the unusually high rate of unemployment, it is unsurprising that labour costs are falling. According to the most recent available figures, year-on-year labour costs fell for three consecutive quarters to the third quarter of 2010. Since euro-wide labour cost figures were first compiled in 1996, there has never been a fall of this size and duration.
Wage developments, therefore, pose no threat to wider price stability. Indeed, given likely productivity gains over the same period, wages would appear to be undershooting – a phenomenon German workers have bafflingly put up with for the past half decade. Perhaps, in this regard at least, Europe is becoming more German. If that is the case, it is not to be welcomed.
If there is no immediate reason to believe the labour market is a source of inflationary pressure, what about producer prices? When these start to rise, higher consumer prices are usually in the pipeline (the feed-through effects take time to make their way down the supply chain to consumers). But, again, the figures show that they pose no threat. Producer prices remain below their pre-crisis levels and the rate at which they are rising is not indicative of an inflationary shock around the corner.
Nor is there any reason to believe that producer prices, or those of any manufactured goods for that matter, are set to take off over the remainder of the year. Levels of capacity utilisation in the manufacturing industry across the euro zone remain below historical norms.
In the first quarter of 2011, 79.1 per cent of manufacturing capacity in the euro zone was being utilised. This is up 10 percentage points from the recessionary trough, registered in the second quarter of 2009, but still five percentage points below the level before the crisis struck (in the second quarter of 2008). In other words, a full one-third of the additional spare capacity created when manufacturing output crashed after the credit crisis erupted has yet to be used up.
A final inflationary indicator that could be spooking the ECB is money supply. The bank’s German lineage means that, despite the very limited value of any measure of money supply in predicting future inflation, it is obliged to consider it carefully. On this measure, inflation is dead. The broadest measure includes notes, money on deposit and other liabilities of financial institutions. It is known as “M3”. It grew by just 1.5 per cent on an annual basis in January. The average growth rate since the euro was launched has been multiples of that, at about 8 per cent.
Finally, if people’s expectations of future inflation were rising, the bank might want to convince them that it is prepared to act pre-emptively. But in the ECB’s monthly bulletin in February, an article assessing inflation expectations concluded that they remain well anchored.
On the basis of available evidence there is no case to be made for immediate interest rate increases to contain inflation.
