Inflation in Rapid Retreat Creates Leeway for Looser Monetary Policy

November 26, 2008

Price data released by Germany today exemplify a remarkable reversal of inflation trends and risks. Import prices dropped 3.6% in October on top of declines of 1.0% in September and 0.8% in August, and the 12-month rate of import price inflation plunged to 2.9% from 7.6% in September and 9.3% in October. Lower oil costs accounted for all that improvement, as non-oil import price inflation of 4.1% was identical to the advance in the twelve months to August.

However, November consumer price data revealed a more widespread retreat of cost pressures. Overall consumer prices fell 0.5%, the fourth monthly decline in a row, with sharply lower price pressures in food as well as energy and tepid clothing prices. On-year German consumer price inflation fell by a whole percentage point to 1.4% and was less than half the recent peak rise in the year to July of 3.3%. German inflation had been at or above 2.0% since September 2007 and not as low as 1.4% since the end of 2006.

The remarkable shift from fear of inflation to fear of deflation raises profound questions about whether ECB policy is really geared to the medium term. The credit crisis began 15-1/2 months ago, yet the ECB raised rates to a cyclical peak eleven months after the onset of the crisis. It did so after the region’s first quarter of negative economic growth and amid survey evidence that positive growth might not resume as quickly as officials were then predicting. Significantly, inflation was still cresting in July. Meanwhile, the return of risk aversion should not have surprised ECB officials, since for years they had warned that financial markets were under-pricing risk and that an inevitable deleveraging of risk might prove disruptive. It wasn’t until after Lehman was permitted to fail that it was fully apparent that deleveraging was taking a worst case scenario. Nevertheless, ECB officials made their last rate hike with knowledge that hopes for a soft landing were not happening in the United States, that Europe was importing economic softness more readily than assumed, and that parts of Asia also were underperforming expectations. In the face of many reasons for further prudent wait-and-see, officials went ahead with another rate increase because inflation during the past twelve months was still climbing and fear that sky-high commodity prices, which turned south with a vengeance but not until mid-July, would continue to press overall inflation upward. The ECB based policy on what had happened — higher Euroland CPI and rising commodity prices — but not on forward-looking information of an unsustainable climb in inflation amid collapsing world demand.

It is inconceivable that the world recession and disinflation would have been any less pronounced if the ECB had not raised interest rates in July or even if it had begun to cut rates in midyear. Nor would any damage have been done to the central bank’s credibility if officials had so acted. In fact, they would have been praised by now for behaving in a forward-looking manner, just as they did when they began to raise interest rates in December 2005 when economic growth prospects still appeared a little shaky. Central bank credibility is impacted by more than a perceived willingness to make tough decisions that preserve the value of money. Competence in doing the right thing to achieve that goal is equally important, and accurate forward-looking forecasting is a part of that skill. The good news is that credibility is a dynamic process. In deciding how much confidence to place in a central bank, investors apply the what-have-you-done-for-me-lately rule. A belated start in easing can be rectified by moving aggressively to make up for lost time. Cutting rates by 50 basis points in back-to-back months (October and November) only looks aggressive, perhaps even excessive, if considered without regard to background context. The faster rate reductions of other central banks and free-falling business conditions reflected in European real-time and survey data suggest that another 50-basis point cut in December would be overly cautious and insufficient. ECB officials from Trichet downward have said nothing to encourage speculation that the cut might be larger than that, however. A history of not wanting to surprise markets leads me to assume next week’s cut will be one of 50 bps to 2.75%, although I’d like to see a larger move.



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