Evidence says the ECB is overreacting

Earlier this week I argued that the ECB’s inflation target of just below 2% is too simplistic, especially during periods of supply-side price shocks: energy, food, VAT hikes. Here’s a menu of reactions to the ECB’s announced rate hike (Trichet used the phrase ‘strong vigilance’, which historically is a leading indicator of a rate hike in the following month): Paul Krugman calls it ‘madness’; David Beckworth sports the ‘black eye’ metaphor; Kantoos is somewhat more explicit in his language; and Warren Mosler goes for the Disney theme.

And then I see that one of my favorite blogs, the Eurointelligence blog, interprets the policy response as warranted in the face of an ‘overheating’ export sector. From Eurointelligence:

(It is our interpretation that the ECB is very keen to drive up the euro’s exchange rate against the dollar to reduce the commodity price shocks, and to reduce the overheating in the export sector. This is why the ECB was keen to signal this interest rate as early as possible, to underline the transatlantic policy gap. We don’t think the ECB intends to hike interest rates to very high absolute levels, though we consider a 2% year-end rate realistic.)

RW: My initial reaction was: what? Am I missing something here? Is the ECB right to be strongly vigilant? Is the export sector (1) overheating? and (2) therefore unmooring Eurozone inflation expectations?


Exhibit 1: Real exports are 1.5% below the pre-crisis level (1H 2008). No overheating there. Based on the chart below, whose data are from Eurostat, I’d even argue that there is a possible stagflationary scenario on the horizon if investment doesn’t pick up.

If it’s not the export sector, perhaps it’s a broader impetus to prices driven by services and consumption goods. No.

Exhibit 2: The chart below illustrates the diffusion of HICP inflation (the ECB’s target inflation index, which is a consistent measure of inflation across the 17-member currency union). I calculate the diffusion index to measure the breadth of prices that are rising at a rate of 2%: > 50 and there’s a larger share of sub-components prices increasing at a greater than 2% annual rate, or
The breadth of Eurozone 2% price gains is very low, 31, or 31% below its historical average (45).

We know that headline inflation is estimated at 2.4% in February, or about 0.4% above the ECB’s comfort zone – perhaps that’s passing through to inflation expectations.

Exhibit 3: The chart below illustrates near-term Eurozone inflation expectations, as measured by the 5-yr inflation swap. (Note: and inflation swap is a market security that allows an investor to hedge against inflation by paying a fixed rate and receiving inflation-linked interest payments in exchange). According to the swap market, inflation expectations are priced at 2.151%; this appears well-anchored especially compared to the 2007 period when it drifted upward.

Another measure of inflation expectations, the ECB’s Survey of Professional Forecasters, sees inflation peaking in 2011 at 1.9%. No unmooring of inflation expectations there.

Related to the chart above, perhaps the ECB is looking at the sharp upward trajectory of inflation expectations in the swap market since October 2010 as unhealthy. No. That trajectory in inflation expectations is just a re-emergence of normalized inflation expectations, as the Fed worked to re-establish the US price trajectory. Global inflation expectations turned from drifting downward to a trend rate. Then perhaps it’s that Eurozone inflation expectations are outpacing those in other developed economies. Again, no.

Exhibit 4: The chart below illustrates the 5y5y forward break even rates of inflation for the US, UK, and the Eurozone, which is from page 84 of the ECB’s February (yes, this month) monthly Bulletin. The Eurozone is definitely the laggard here!

My interpretation of these statistics – and yes, there are many ways to measure inflation – is that the ECB is overreacting to the inflation pressures coming from commodity prices, energy prices, and VAT hikes. The liquidity squeeze is afoot.

Rebecca Wilder