Market Economics | Interest Rate Strategy - BNP PARIBAS ...

ECB: Bark or Bite?
• The ECB has signalled increased anxiety
over the upside risks to inflation.
• How labour costs and inflation expectations
evolve will be key to whether this translates into
‘early’ increases in the refinancing rate.
• The assessment of labour cost trends in the
January Monthly Bulletin was similar to that in
December, i.e. relatively benign.
• Broad money and bank lending data do not
signal a pressing need for rate hikes either.
• The key risks to our call of the ECB on hold
through 2011 are persistently high commodity
prices and a ‘normalisation’ approach to policy.
The ECB press conference on 13 January revealed
increased anxiety over upside risks to inflation.
Below we discuss the probability that this increased
concern over inflation prospects will translate into an
‘early’ policy tightening.
Shifting risks
Relevant extracts from the Introductory Statement to
the January press conference are in Box 1. The key
point was that inflation had turned out higher than the
ECB had expected, largely due to energy prices.
While this had not yet led to a change in the mediumterm
assessment of inflation developments, the ECB
would need to monitor developments very closely to
ensure that this conclusion remains valid.
The market has now fully priced in the start of the
tightening cycle in the second half of this year.
Whether the ECB will deliver in this timeframe will
depend primarily on two issues. First, whether what
is currently a short-term inflation problem driven by
energy prices turns into a more persistent problem
via second-round effects on core inflation. Second,
whether inflation expectations are at risk of becoming
unanchored. Below we look at each issue in turn.
Ups and downs
Chart 1 shows our forecast for inflation based on our
‘in house’ oil price forecast: this assumes a fall in the
price of Brent to a USD88/Bbl average in Q1. On this
assumption, and given energy price base effects,
headline inflation is expected to fall from 2.4% y/y in
February to 1.9% in April. Core inflation is also set to
remain low.
Box 1: Extracts from ECB Introductory Statement
“We see evidence of short-term upward pressure on
overall inflation, mainly owing to energy prices, but this
has not so far affected our assessment that price
developments will remain in line with price stability over
the policy-relevant horizon. At the same time, very close
monitoring is warranted.
Inflation expectations remain firmly anchored in line with
our aim of keeping inflation rates below, but close to, 2%
over the medium term. The firm anchoring of inflation
expectations is of the essence.
HICP inflation was 2.2% in December. This is somewhat
higher than expected and largely reflects higher energy
prices. Looking ahead to the next few months, inflation
rates could temporarily increase further. They are likely to
stay slightly above 2%, largely owing to commodity price
developments, before moderating again towards the end
of the year.
Risks to the medium-term outlook for price developments
are still broadly balanced but could move to the upside.
Upside risks relate, in particular, to developments in
energy and non-energy commodity prices.”
13 January 2011
Source: ECB
The ECB is also expecting that inflation will moderate
from the spring, as is clear from the press conference
– again, see Box 1.
The shorter is the deviation of headline inflation from
the ‘below but close to 2%’ objective, the lower is the
risk of second-round effects and an upward shift in
inflation expectations. So, if the ECB’s expectation of
lower inflation is borne out, anxiety over upside risks
to inflation should recede and with it, the probability
of early hikes in the refinancing rate.
On the basis of our assumption of a pick up in oil
prices subsequently, we look for inflation to rise back
above 2% in the second half of the year, before it
falls back again in 2012 as base effects related to
recent energy and food price gains kick in.
What pay pressures?
Chart 2 shows the three key measures of pay trends
in the eurozone. Across the board, they show low y/y
rates of change – remarkably low, in fact. The rate of
increase in negotiated wages fell below 2% y/y in
early 2010 for the first time in the series’ history and
the current growth rate, of 1.4% y/y as of Q3, is the
lowest since the early 1990s.
Ken Wattret 20 January 2011
Market Mover
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