ECB Says Upside Inflation Risks Have Diminished

October 2, 2008

The new statement from the ECB Governing Council constitutes a start in preparing markets for a rate cut.  This is what investors and analysts were hoping and expecting to see.  Typically the ECB’s tone did not swing first circle.  Inflation risks around a forecast that expects above-target readings “for some time” are still skewed to the upside.  However, officials admitted for the first time in this cycle that such price risks are diminishing, particularly for the medium term, as a result of weakening euro area activity, contracting domestic demand, and tighter financial conditions.  This is a huge yet obvious concession that the banking crisis will change the needed direction of monetary policy.

Without using the R-word, the statement all but concedes that a recession began in the second quarter.  The statement cites “an extraordinarily high level of uncertainty” associated with medium-term economic prospects, declares that downside growth risks are increasing, says that a recovery in the course of 2009 based on lower oil prices and ongoing emerging market demand will be “gradual,” and even hints that such a recovery might not even occur next year.   The statement abandons a detailed discussion of supportive components in aggregate demand.  To paraphrase Will Rogers, if you have nothing good to say, it’s best to say as little as possible.

The statement hedges in stern language that upside inflation risks, while diminished, have not disappeared.  Unit Labor costs rose 3.4% in the year to 2Q08, up sharply from several years with increases “in the order of 1-1.5%.”  The statement complains more vehemently about schemes that index nominal wages to consumer prices automatically and warns that wage negotiations and corporate price-setting behavior are being watched keenly by officials.  Several other price risks are mentioned, including the lagged effect of past commodity price increases, possible renewed commodity price gains, second-round effects on prices and wages, and higher indirect taxes and administered prices.  Anchoring expected inflation is more important now than at times with lesser uncertainty about the future.  With such tough talk, ECB officials left open the possibility of not easing until December or even 2009.  Future policy will be contingent.  If the banking crisis gets worse, officials will have to act.  But if wage talks especially involving the German engineering workers, who want an 8% raise, produce an unsatisfactory result from the ECB’s standpoint, officials will try to delay easing longer than market players assume.  That is a lot of “ifs,” and much of the discussion about the priority of restoring price stability is intended to avoid any erosion of the bank’s credibility as an inflation fighter.  Take it for what it is, verbal posturing.

In Q & A, Trichet revealed that a rate cut had been discussed today, although the decision to keep the refinancing rate at 4.25% was taken unanimously.  He would not say if rates might be cut as soon as November when asked that question.  The lack of a denial implies possibility, if not probability.  The policy bias has clearly swung toward ease from a tightening bias just two months earlier and a rate increase three months earlier.  Trichet defended the ECB’s separation of a flexible and forceful approach to keeping the banking system liquid from an underlying monetary policy that retains the highest target rates since the 9/11 attacks, but he also said that this stance had stabilized inflation expectations, which were mounting earlier this year.

Market expectations for a rate cut next month will not be quelled by the ECB statement and Trichet’s comments.  Weak economic data, persistent bank reluctance to deal with one another, jittery markets, and probable further bailouts over the coming month will raise investor confidence in such a rate cut over coming weeks.  There will be comments by Trichet and other ECB officials, which more likely than not will encourage rate cut speculation.  If markets get ahead of themselves, ECB will not wait for the November meeting to correct the misconception.  One very important data release will be September CPI details and whether core inflation has moved lower as I suspect.  At this point, a rate change in November is probably a better-than-even bet.  But as Trichet said, exceptional uncertainty is keeping all elements of the crisis very fluid, and that includes the response of officials and when they make it.



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