The European Central Bank (ECB) is fighting a lonely battle against a global trend of monetary recklessness.
Eurozone inflation is largely driven by the same outside factors stoking inflation in the rest of the world: rising commodity prices fuelled by the US Federal Reserve’s cheap-money policy. Morgan Stanley counts around 50 countries with double-digit inflation. Many have linked their currencies to the dollar, forcing them to import the Fed’s loose monetary policy.
But unlike the Fed and other central banks, ECB seems determined to avoid the stagflation mistakes of the 1970s. Back then, policymakers failed to prevent inflation from spreading throughout the economy as workers won higher wages and firms passed on higher costs to consumers. Inflation became embedded in wage and price rises, damaging output and employment for years. A modest monetary tightening now may prevent the need for a much harsher cure down the road.
The fear is that the higher prices “may become entrenched in private inflation expectation and lead to second-round effects in price and wage setting,” ECB president Jean-Claude Trichet told the European parliament last week.
The European Commission’s consumer survey already shows a rise in inflation expectations among the public. Wages have started to pick up as well. Monthly labour costs rose 3.3% in the first quarter, up from 2.9% in late 2007. The main cause is the de facto indexation of Spanish wages to inflation, which pushed up Spanish labour costs 5.7%. Germany’s public sector workers won a 5% pay raise this year, and a wage deal with Germany’s largest union, IG Metall, is due this fall.
ECB’s determination to maintain its inflation fighting credibility comes amid hardening political pressure to focus on the slowdown in growth. Recent industry confidence indicators suggest that the economy has slowed in the second quarter and is heading further south. High energy prices curb consumer spending, while exporters are increasingly hurt by the strong euro.
The French President is of course never far away when it comes to attacking the Frankfurt-based bank.
Speaking on Monday night, a day before assuming the rotating European Union presidency, Nicolas Sarkozy assured ECB that its “independence must be preserved” — only to immediately undermine that very independence. The bank “should ask itself about growth and not simply inflation” was his unsolicited advice (to ECB).
Even the Germans, until now rather cocky, are getting nervous. “ECB should take into account the consequences of an interest rate hike,” German finance minister Peer Steinbrück had said on Tuesday.
Perhaps somebody should remind Steinbrück of his predecessor in the 1960s, Karl Schiller, also a Social Democrat, who famously quipped that price stability “might not be everything, but without (price) stability, everything is nothing.”
Inflation is now twice ECB’s comfort zone of 2%, and in the near term will only get worse. It will probably peak at about 4.3% in August or September and remain above 3% well into next year, according to most forecasts. A hike of 25 basis points may not be enough to anchor inflation expectations.
“Inflationary pressures seem to us to constitute an even more significant threat to growth than the subprime crisis,” Christian Noyer, governor of the Bank of France, told Le Monde last week. Perhaps the Fed should take some French lessons?
The Wall Street Journal