The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.
Today the ECB announced that it would keep the refi rate unchanged at 1%, however, Trichet made it quite clear that rate hikes at the next meeting cannot be ruled out (rather should be ruled in). The market response was pretty strong: bond markets are now pricing in 75 basis points of rate hikes this year, which would take the refi rate to 1.75% by the end of 2011; the euro’s close to breaking the 1.40 mark; and the 2-year yield is 13 basis points higher on the day.
The trigger, in my view, was the ECB’s increased inflation projection:
The March 2011 ECB staff macroeconomic projections for the euro area foresee annual HICP inflation in a range between 2.0% and 2.6% for 2011 and between 1.0% and 2.4% for 2012.
The fact that the ECB is now projecting 2012 inflation upwards of 2.4% , which exceeds by leaps and bounds their 2% target in ‘ECB talk’, implies that the committee sees the medium-term outlook on inflation as seriously biased toward the upside. For the ECB, this means policy is way too accommodative.
Let’s step back a moment, though. Despite the ‘strong’ growth in the Eurozone, Germany, the largest Eurozone economy, has not fully recovered it’s GDP lost during the recession. As of Q4 2010, GDP remains 1.4% below its 2008 peak.
In my view, the ECB’s policy objective is too simplistic. During times of supply-side inflation shocks to food and commodities (i.e., wheat droughts or Middle East unrest), headline inflation overestimates the true impetus to prices.
Core and service prices are still very muted, while it’s goods prices that’s driving the price spikes.