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A hot inflation summer; can the ECB sweat it out?

Tue, Jun 3 2008, 07:58 GMT
by KBC Market Research Desk

KBC Bank

• • Rising energy and food prices have dramatically changed the short-term inflation outlook and …
  

• • … raise fears about an ECB rate hike around year end
  

• • We however believe deteriorating growth outlook will prevent second round effects from materializing and expect inflation to fall back towards 2% till the end of 2009
  

• • As such, we now expect rates to remain on hold this year and to fall to 3.50% next year

Concerns that the global economy may be facing its greatest inflation threat for decades have dramatically changed sentiment towards interest rates of late. For most of the early part of 2008, the risk of a sharp downturn in global economic activity had underpinned hopes for lower interest rates. However, financial markets now take the view that the risk of higher fuel and food prices spilling over into a more generalised deterioration in inflation will be the dominant influence on Central Banks words and actions. In the US, focus has turned to when and how quickly the Federal Reserve might raise policy rates. In the UK, traders think that stubbornly high inflation will prevent the Bank of England taking action to support a sharp deteriorating Economic outlook. In the Euro area, a rise in ECB rates is now predicted before end year.

Although we think that the prospect of a marked slowdown in the Euro area economic growth remains an issue for the European Central Bank, worries about inflation are an altogether more pressing concern. Unless there is a broadly based deterioration in inflation we still think the next change in ECB policy rates will be a reduction however this is now a far more distant prospect than appeared likely even a month ago. The sharp rise in energy costs in the interim means our earlier expectations of Autumn rate cuts no longer looks plausible. Indeed, there appears little prospect of an ECB rate cut before the end of the year. Instead, in the next couple of months fear about higher ECB rates could well intensify.

Although there has been some easing in oil prices in the past couple of days, the sharp rise from below $90 in the middle of January to $135 in the past weeks has dramatically changed the outlook for Euro area inflation between now and end year. More importantly, the sustained upward pressure on fuel and food costs threaten ‘second round’ increases in the prices of a range of other goods and services. This threat is also reflected in the recent sharp rise in longer-term financial inflation expectations derived from French inflation linked bonds. In recent days, the break even inflation rate derived from bonds with a maturity until 2020/21 set a new high at around 2.60%. In such circumstances, the ECB’s mandate requires that they talk tough and hold out the threat of a further increase in interest rates. The tight relationship between oil prices and financial inflation expectations however also indicates that once oil prices fall, the inflation outlook may clear up pretty soon. Over the past two months, the price of several agricultural commodities, like wheat and rice, have already plunged lower reminding that commodities are no one-way bet. Nevertheless, until the risk of permanently higher inflation diminishes, markets will continue to focus on the possibility of a further increase in ECB rates

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Published on  Tue, Jun 3 2008, 08:05 GMT

Archive

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• ECB threatens July rate rise
  Published On Fri, Jun 6 2008, 14:27 GMT
• A hot inflation summer; can the ECB sweat it out?
  Published On Tue, Jun 3 2008, 07:58 GMT
• ECB: Uncomfortable but unmoved
  Published On Fri, May 9 2008, 09:38 GMT
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