From Ben to Big Ben
In January, eurozone inflation rose to 3.2 per cent from 3.1 per cent in December. For the European Central Bank (ECB) this is an inflation rate a good percentage point too high. The ECB's self-proclaimed inflation target is "a year-on-year increase in...
In January, eurozone inflation rose to 3.2 per cent from 3.1 per cent in December. For the European Central Bank (ECB) this is an inflation rate a good percentage point too high. The ECB's self-proclaimed inflation target is "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the eurozone of below 2 per cent. Price stability is to be defined over the medium term". However, for some ECB members, notably those of a Germanic temperament, this increase is worrying.
The ECB would doubtless argue that, with the forthcoming wage round in Germany, it would be wrong to be too relaxed in the light of an inflation rate which has strayed a little too far from target. The last thing the ECB wants is to underwrite wage demands which might, in time, lead to higher inflation. But how big a threat are the wage increases? First, they relate mostly to Germany, which may be the biggest economy in the eurozone but certainly does not account for the majority of the eurozone economy. Second, even if wage increases did come through, higher inflation need not follow. The eurozone economy is slowing down. Higher wages would, in these circumstances, trigger higher unemployment, not higher inflation.
While the ECB refuses to cut interest rates, the Federal Reserve has been slashing rates despite an inflation rate of over 4 per cent. On the face of it, then, the Federal Reserve and the ECB have very different views about monetary policy.
One central bank has members ready to raise interest rates with inflation a touch over 3 per cent. The other is full of members providing some of the biggest rate cuts ever seen despite inflation of over 4 per cent. However, the US housing market has been in a state of collapse for a couple of years now. Also employment fell by 17,000 in January, the first drop in four and a half years.
In the eurozone, the signs of weakness are nothing like as worrying and, even in the UK, the property market only recently hit a brick wall. Cyclically, then, there are plenty of reasons for the ECB and the Bank of England to exercise more caution than the Fed. Moreover, the ECB and Bank of England could argue, with plenty of justification, that the Federal Reserve has, for too long, made a habit of taking its eye off the inflationary ball. The Fed spent most of its time in the middle years of this decade looking at so-called "core" inflation, which excludes the supposedly volatile bits like food and energy. For the most part, this measure behaved reasonably well. However, far from being volatile, food and energy prices rose year in, year out, a reflection of persistently higher demand for raw materials from rapidly industrialising countries such as China and India. All three central banks need to think carefully about three key issues. First, they have to consider their economies' vulnerability to the sub-prime crisis. Although the knee-jerk reaction is to see this as purely an American phenomenon, the crisis has, however, spread out on both sides of the Atlantic. There are plenty of sub-prime borrowers in the UK and Spain. Meanwhile, many of the investors in asset-backed securities (the pieces of paper which provided the fuel for the housing fire) who, now, are losing money, are based in Europe. And it is not only in New York that banks are under pressure. We are seeing the beginnings of a transatlantic credit crunch.
Second, they need to think about the second-round effects stemming from the sub-prime crisis. It is easy enough to argue that Germany, for example, has little direct exposure (not withstanding the problems faced by IKB and Sachsen LB last year). However, this ignores Germany's trade vulnerabilities. Germany, after all, is an economy which does well when everybody else is doing well but tends to slow down when other economies suffer. Third, the central banks need to consider inflation in a medium-term context. Yes, inflation is a little too high at the moment. But to worry too much about current inflation and, as a result, to stand idly by while the financial system is in danger of imploding would be a huge error. It is, after all, what the Japanese did at the beginning of the 1990s, before their economy tumbled into deflation. The defence of inflation credibility can, sometimes, be taken too far.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
The ECB would doubtless argue that, with the forthcoming wage round in Germany, it would be wrong to be too relaxed in the light of an inflation rate which has strayed a little too far from target. The last thing the ECB wants is to underwrite wage demands which might, in time, lead to higher inflation. But how big a threat are the wage increases? First, they relate mostly to Germany, which may be the biggest economy in the eurozone but certainly does not account for the majority of the eurozone economy. Second, even if wage increases did come through, higher inflation need not follow. The eurozone economy is slowing down. Higher wages would, in these circumstances, trigger higher unemployment, not higher inflation.
While the ECB refuses to cut interest rates, the Federal Reserve has been slashing rates despite an inflation rate of over 4 per cent. On the face of it, then, the Federal Reserve and the ECB have very different views about monetary policy.
One central bank has members ready to raise interest rates with inflation a touch over 3 per cent. The other is full of members providing some of the biggest rate cuts ever seen despite inflation of over 4 per cent. However, the US housing market has been in a state of collapse for a couple of years now. Also employment fell by 17,000 in January, the first drop in four and a half years.
In the eurozone, the signs of weakness are nothing like as worrying and, even in the UK, the property market only recently hit a brick wall. Cyclically, then, there are plenty of reasons for the ECB and the Bank of England to exercise more caution than the Fed. Moreover, the ECB and Bank of England could argue, with plenty of justification, that the Federal Reserve has, for too long, made a habit of taking its eye off the inflationary ball. The Fed spent most of its time in the middle years of this decade looking at so-called "core" inflation, which excludes the supposedly volatile bits like food and energy. For the most part, this measure behaved reasonably well. However, far from being volatile, food and energy prices rose year in, year out, a reflection of persistently higher demand for raw materials from rapidly industrialising countries such as China and India. All three central banks need to think carefully about three key issues. First, they have to consider their economies' vulnerability to the sub-prime crisis. Although the knee-jerk reaction is to see this as purely an American phenomenon, the crisis has, however, spread out on both sides of the Atlantic. There are plenty of sub-prime borrowers in the UK and Spain. Meanwhile, many of the investors in asset-backed securities (the pieces of paper which provided the fuel for the housing fire) who, now, are losing money, are based in Europe. And it is not only in New York that banks are under pressure. We are seeing the beginnings of a transatlantic credit crunch.
Second, they need to think about the second-round effects stemming from the sub-prime crisis. It is easy enough to argue that Germany, for example, has little direct exposure (not withstanding the problems faced by IKB and Sachsen LB last year). However, this ignores Germany's trade vulnerabilities. Germany, after all, is an economy which does well when everybody else is doing well but tends to slow down when other economies suffer. Third, the central banks need to consider inflation in a medium-term context. Yes, inflation is a little too high at the moment. But to worry too much about current inflation and, as a result, to stand idly by while the financial system is in danger of imploding would be a huge error. It is, after all, what the Japanese did at the beginning of the 1990s, before their economy tumbled into deflation. The defence of inflation credibility can, sometimes, be taken too far.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.