Can The CPI Influence Monetary Policy Decisions?

by: Matteo Radaelli

The major central banks are widely expected to further ease monetary policy in the next few months amid the weakening of global economic growth: The Fed may implement a QE3 program, the ECB may reverse the tightening of monetary policy decided in 2011 (+0.25% to 1.25% in April and +0.25% to 1.5% in July) and the BoE may increase the size of the asset purchase program.

However, the timing of the decision is highly uncertain. A relevant factor to consider going forward is the development of inflation that may have an impact on the monetary policy in the short term.

A clear example is the situation in the UK. In August, the CPI rose from 4.4% y/y to 4.5% y/y in line with market expectations. However, the breakdown of the data indicated that the CPI may extend the recent upward trend in the next few months. James Knightley of Ing Financial Markets said:

Utility bill hikes contributed less than we expected, which suggests more upside pressure coming from this component in September. Clothing and furniture prices accelerated more than expected though, with the annual rate of inflation for these components rising at their fastest rates since the series began in 1997. Given the lagged effects of increases in food commodity prices and the ongoing pass through of utility bill increases we still look for inflation to break above 5% in the next couple of months.

Despite the fact that all of the economists interviewed after the release of the data projected the CPI to decline sharply in 2012, for the BoE it may difficult to implement a QE2 program when inflation is more than double the 2% target of the BoE. For this reason, in our view is that easing of monetary policy is not likely to be implemented before 2012.

Also, the ECB is not likely to cut interest rates before 2012. The CPI data for August, due for release on Thursday, September 15, is likely to confirm that CPI is still well above the 2% target of the ECB (the Eurostat flash estimate saw the CPI unchanged at 2.5% y/y in August). The ECB changed its bias on inflation in the latest Trichet press conference, indicating that risk on inflation is balanced. However, it is highly unlikely that the ECB may decide to ease monetary policy until some signs of an easing of inflationary pressures will be available. With the CPI expected to remain above 2% till year-end, we do not see a rate cut before 2012.

Finally, the CPI data due for release on Thursday the 15th in the USA may have an impact of the FOMC’s meeting scheduled on September 20/21st. Indeed, the CPI is expected to remain unchanged at 3.6% and the CPI core to rise from 1.8% y/y to 1.9% y/y. Fed Chairman Bernanke stated that the main difference between now and August 2010, when the QE2 program was decided, is the level of CPI: Back in August 2010, the CPI was at 1.2% y/y and the CPI core at 0.9%. Should the CPI confirm markets expectations, the Fed may decide to postpone a further easing of monetary policy to the November’s meeting.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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