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Friday, 6 May 2011

Inflation in the Eurozone vs. the ECB rate hike that didn’t come. Why the things went like the way they did?!

It was widely expected that Jean-Claude Trichet, the president of the ECB would announce a second rate hike of 0.25% on May 5, 2011. In April he had used the magic words “strong vigilance” a number of times (the same magic words he always used at times of rate hikes) and followers of the French ECB president expected him to increase the interest rates for at least three consecutive months. And on May 5th Jean-Claude Trichet … didn’t!

Let’s have a look at the May 5. speech of Trichet and at the latest inflation figures, as collected by the Dutch Central Bureau of Statistics (CBS) and Eurostat, the European bureau of statistics.

Here is an extensive summary of the speech of Jean-Claude Trichet, combined with my comment: 
Based on its regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged following the 25-basis point increase on 7 April 2011. The information that has become available since then confirms our assessment that an adjustment of the very accommodative monetary policy stance was warranted.
In plain English: “we did it right, when we increased the interest rate in April ”. And I can't blame him for thinking like this.
Following the 0.3% quarter-on-quarter increase in euro area real GDP in the fourth quarter of 2010, recent statistical releases and survey-based indicators point towards a continued positive underlying momentum of economic activity in the euro area during the first quarter of 2011 and at the beginning of the second quarter. Looking ahead, euro area exports should be supported by the ongoing expansion in the world economy. At the same time, taking into account the high level of business confidence in the euro area, private sector domestic demand should contribute increasingly to economic growth, benefiting from the accommodative monetary policy stance and the measures adopted to improve the functioning of the financial system. However, activity is expected to continue to be dampened somewhat by the process of balance sheet adjustment in various sectors.
Again in plain English: The economic activity in the Eurozone in Q1 and at the beginning of Q2 looks OK. The outlook for the European export is good, due to the expanding world economy. The private sector is lagging somewhat, because banks and companies want to increase the solvability on their balance sheet by lending, respectively borrowing less money.
This makes sense: banks in the European countries are looking ahead to the increased demands for Core Tier 1-capital as a result of Basel III. The Dutch national bank DNB estimated this amount for The Netherlands only to be €10 bln. In my opinion this amount should be even higher: very shortly I will calculate my version of the amount based on the annual reports of the four largest banks in The Netherlands, i.e. ING Bank, Rabobank, SNS Bank and ABN AMRO.
The needed core tier 1 capital will be even higher in countries like the PIIGS (Portugal, Ireland, Italy, Greece and Spain) and the Eastern European countries, as they have in common a worse credit rating than the German and Dutch banks. The quickest way to increase your Core Tier 1 capital ratio is to lend less money to companies and private consumers.
There is another factor: the current (youth) unemployment in the countries of the Euro zone and the problem that the credit crisis has not by any means finished, makes private consumption to be lagging. And this has its effects on the business-to-business trade too.
Look for instance to this table of the Dutch Central Bureau of Statistics on Consumer Confidence from April 2011. Although the consumer confidence is creeping towards the 0% line, it is nowhere near there yet.
Consumer confidence (
In the Governing Council’s assessment, the risks to this economic outlook remain broadly balanced in an environment of elevated uncertainty. On the one hand, global trade may continue to grow more rapidly than expected, thereby supporting euro area exports. Moreover, strong business confidence could provide more support to domestic economic activity in the euro area than currently expected. On the other hand, downside risks relate to the ongoing tensions in some segments of the financial markets that may potentially spill over to the euro area real economy. Downside risks also relate to further increases in energy prices, particularly in view of ongoing geopolitical tensions in North Africa and the Middle East, and to protectionist pressures and the possibility of a disorderly correction of global imbalances. Finally, there are still potential risks stemming from the economic impact on the euro area and elsewhere of the natural and nuclear disasters in Japan.

With regard to the aforementioned table for consumer confidence, I don’t think personally that the consumers care about “the ongoing tensions in some sectors of the financial markets” or “the ongoing geopolitical tensions” and a “disorderly correction of global imbalances”. 
In my opinion the negative consumer mood and lack of consumption in Germany, The Netherlands and other important countries of the Euro zone are THE main downside risks. The fact that banks aren’t trusted yet to be financially rock solid doesn’t help either to trigger a broader consumption in the European countries. People want to keep some cash money ‘for a rainy day’, instead of spending it on consumer electronics.

Regarding to exports, the main problem is that the global export, although according to Bloomberg growing by 8% this year, is still on a considerable low level. You can see this by looking at the Baltic Dry index for shipping, which measures the costs per metric ton of sea transport.

Baltic Dry 5Y index (

In 2008 it was on a record 11793 points and today it was at 1269 points. This means there is still a large overcapacity in container ships, compared to the amount of goods to be transported. This tells you that export is nowhere near 2008 levels yet. And for intra-European export applies that one country’s surplus is another country’s deficit.

With regard to price developments, euro area annual HICP inflation was 2.8% in April according to Eurostat’s flash estimate, after 2.7% in March. The increase in inflation rates during the first four months of 2011 largely reflects higher commodity prices. Looking ahead, inflation rates are likely to stay clearly above 2% over the coming months. Upward pressure on inflation, mainly from energy and commodity prices, is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not translate into second-round effects in price and wage-setting behaviour and lead to broad-based inflationary pressures. Inflation expectations must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term.
In plain English: the inflation is slightly over the 2% that is desirable. Main causes are the rising commodity and energy prices. The ECB is afraid that this eventually might lead to a price-wage spiral.
Turning to the monetary analysis, the annual growth rate of M3 increased to 2.3% in March 2011, from 2.1% in February. Looking through the recent volatility in broad money growth caused by special factors, M3 growth has continued to edge up over recent months. The annual growth rate of loans to the private sector remained broadly unchanged at 2.5% in March, after 2.6% in February. Overall, the underlying pace of monetary expansion is gradually picking up, but it remains moderate. At the same time, monetary liquidity accumulated prior to the period of financial market tensions remains ample and may facilitate the accommodation of price pressures in the euro area.
The supply of money (M3 = money + money-equivalent valuables and deposits) has grown, but it didn’t so much that acute danger of substantial inflation exists. Still the large amount of available money might trigger price increases.
It is of the utmost importance that substantial and far-reaching structural reforms be implemented urgently in the euro area in order to strengthen its growth potential, competitiveness and flexibility. In particular, countries which have high fiscal and external deficits or which are suffering from a loss of competitiveness should embark on comprehensive economic reforms. In the case of product markets, policies that enhance competition and innovation should, in particular, be further pursued to speed up restructuring and to bring about improvements in productivity. Regarding the labour market, the priority must be to enhance wage flexibility and incentives to work, and to remove labour market rigidities.
Read here: the problems in the PIIGS, concerning their tax deficits, trade deficits, lack of competitiveness and inflexibility of the labour force, need to be solved before big steps with the interest rate can be executed.
Summarized you could say that the reasons not to increase interest rates were more important than the reasons to increase the interest rate. The large amount of money and money-equivalents in the market doesn’t weigh up against the lagging private consumption in Europe and the harsh economic situation in the PIIGS. A rate hike at this moment could give those countries the final push into the abyss. And we should not exaggerate being positive on the economic situation in Germany, The Netherlands and France. All signals for private consumption there are at least on orange, but probably even on red. And the global export, although growing this year with about 8% is nowhere near the export in May 2008.
Although as a saver, I hate the low current interest rates that make it almost useless to put your money on the bank,  I think that generally speaking Jean-Claude Trichet made a sensible decision.

And how high is the inflation in Europe currently? Please look at this table, courtesy of CBS.
European Inflation Rate (
This table shows that the inflation is for most European countries between 2% and 4%, This is considered to be too high, but it is nowhere near the 7 to 8% that is currently haunting president Hu Jintao of China.

Only Greece, Rumania, Hungary, Bulgaria and Estonia  have reasons to be worried on their inflation figures, as these exceed the 4%. However, the living standards in these countries (except for Greece) are still very low, compared to the other European countries. It makes sense that they have some catching up to do.

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