Friday, March 4, 2011

ECB: Too hawkish?

European Central Bank President Jean-Claude Trichet has signalled an interest rate increase as early as next month.

Regular readers will be aware of our view that given the structural nature of the recession in developed markets, spare capacity may not be as large as we think. That means potential growth is lower – so capacity constraints will get hit earlier in the cycle this time around.

But at the moment it seems to us that the growth outlook in Europe and in other developed economies is still too fragile and uncertain to be tightening monetary policy. Importantly we still don’t know what impact tighter fiscal policy will have on growth. Core inflation is ticking up in some countries, but it is still low and wage pressures are generally contained.

Current inflation pressures are a commodity price phenomenon. To be fair, Trichet has indicated his primary inflation concern is with the second-round effects of higher commodity prices.

If we are concerned about the inflation impact of rising commodity prices we need to believe prices are now moving structurally (rather than cyclically) higher. If that’s the case, inflation has become a global phenomenon, requiring a co-ordinated global response. The first phase of that fight would obviously be to end quantitative easing in the US and more flexible exchange rate policies in emerging economies. We will talk more about this in QSO.