As I departed Europe last week my final impression was that average Europeans, whether they be Germans, Italians, or Maltese, were all concerned about the same thing, price inflation. Thursday, ECB President Trichet managed to roil currency markets by talking tough on inflation:
We are permanently alert. We are never pre-committed not to move interest rates, and our level of interest rates is designed to deliver price stability. As regards monetary policy, it is absolutely crystal clear that we will always do what is necessary and be credible to deliver price stability.
Trichet went on to say:
Risks to this economic outlook are still slightly tilted to the downside……A more favorable economic environment should be exploited to make faster progress with fiscal consolidation.
To sum it up, Trichet warned markets that the ECB will act to maintain price stability (defined by the ECB as long term inflation rates not exceeding 2%) and indicated that there are some troubling inflationary signs. However, the ECB will not adjust monetary policy due to short term inflation fluctuations which have resulted primarily due to the recent rapid increase in the price of oil; therefore, it will take a more serious and sustained increase in food and energy prices for the ECB to tighten monetary policy.
While the EU/US (headline US CPI reported Friday morning increased at the fastest pace since May ’09) are just beginning to feel the first touches of inflation, Asia is experiencing somewhat alarming levels of inflation. India’s Wholesale Price Index rose 8.43% year over year in December and China continued to tighten monetary policy in an effort to combat inflation by raising bank reserve requirements overnight. Meanwhile, rioting and civil unrest resulting from food and energy inflation has erupted in North Africa. In fact, Tunisia has just seen a coup d’etat occur Friday that was primarily the result of civil unrest due to food and energy price inflation and high unemployment.
I had previously thought the possibility of the ECB tightening monetary policy was highly remote but Thursday’s comments from Trichet followed by Friday’s comments by Bundesbank President Weber forced me to reconsider. Can the ECB seriously consider monetary policy tightening while Italy/Portugal/Spain etc. teeter on the brink of stagnant-zero real GDP growth rates? The ECB certainly can tighten monetary policy if they deem that there is a real threat to price stability in the intermediate to long term. However, they also must weigh the consequences of their actions which could be potentially catastrophic for the euro area (EA).
Spain currently has real GDP growth only slightly above zero at .2%, while the Spanish unemployment rate stands at 20.8% with youth unemployment (ages 16-24) currently above 40%. One must also remember that the aforementioned economic statistics have benefited from massive fiscal stimulus policies which have helped to balloon Spain’s annual deficit to GDP ratio to above 11%. Clearly, Spain should be employing the most accommodative monetary policy that it possibly can. With such high rates of unemployment and a disenfranchised younger generation, Spain is not in the mood for any tightening of monetary policy whatsoever. It is essentially a given that Greece and Ireland are so deep in the muck that a 50-100 basis point change in the ECB refinancing rate will have little effect upon them. However, this is not the same for a country such as Spain which has yet to succumb fully and is trying to pull itself out of the economic abyss.
I believe even a modestly tighter monetary policy stance from the ECB could be the ‘straw that broke the camel’s back’ economically for the weaker Eurozone Member States. Of course, this is the fatal flaw in implementing a single monetary policy for so many different countries with much different export economies, growth rates, labor forces etc. Either the ECB will be too loose which will cause Germany to overheat with high inflation or the ECB will be too tight and damage any potential nascent economic rebound in the weaker EA Member States. I question how much economic pain young Spaniards can endure before they say enough is enough. The chart below perfectly illustrates the challenge the ECB faces; with such varying unemployment rates, how can the ECB effectively abide by its single mandate of maintaining price stability? I don’t believe it is possible…
Click to enlarge
