ECB fuels inflation, be long commodities

Some readers might think that the title of this article is foolish. However, the ECB has repeated the mistake it made in July 2008, which had pushed crude oil prices to almost 150$/bbl. We will explain the reasons, why it was wrong to hike interest rates. The result of the ECB monetary policy will be that commodity prices increase further and head line inflation is not going to decline in the near term.

We have pointed out in this blog several times that there is a difference between a change in relative prices and inflation. Inflation is normally defined as a general rise in the level of prices or as an adage describes it, the tight lift all boats. Weather conditions or geo-political events, which are all outside the control of monetary policy, could have an impact on the price of some goods, especially in the energy or agricultural sector. However, the headline indices of consumer or producer prices show an accelerated increase in both cases. A first step to analyze whether prices rise stronger over all groups of goods and services or only for some goods, which have a higher weight in the headline index, would be to look at core inflation indices. This is the way how the Fed proceeds. Its inflation gauge is the core PCE deflator. In the eurozone, the headline inflation rate accelerated in March according to the flash estimate from 2.4% in the previous month to 2.6%. However, the core HICP was only at 1.0% in February. Thus, a close look at both price indicators would have shown the ECB that headline inflation is only driven by rising energy and food prices.

In Keynesian macroeconomic models, inflation is the result of aggregate demand exceeding aggregate supply. One indicator to observe in this respect is the capacity utilization rate. Rising demand would push prices higher in the case that capacities are fully utilized and companies could not meet higher demand by increasing production. At 79.2% in the first quarter of this year, there are still ample spare capacities and a rate hike to restrain demand was not necessary. Also unit labor costs did not argue for a rate hike in the current environment.

But also the monetary indicators don’t support the arguments for the 25bp rate hike. The broad money stock M3 rose by just 1.5% yoy in January. Credit to the private sector was 2.0% higher than in the same month of 2010. Thus, the monetary expansion is still tame and does not indicate that domestic inflationary pressure would be in the pipeline.

As in July 2008, the ECB reacted on the inflation expectations of professional forecasters. They lifted their expectations for inflation to 2.6%, which triggered the change of the ECB council’s assessment of its policy stance at the March meeting and lead to the decision to raise the refinancing rate from 1.0 to 1.25%. The statement of ECB president Trichet during the press conference had been understand that more rate hikes would have to be expected as the wording used was in the past the indication that another rate hike would follow. However, Mr. Trichet also emphasized that this move was not the start of a series of rate hikes.

The rate hike was not only not necessary, it is also counterproductive. If the intention of the ECB was to reduce inflation expectations, it will fail miserably. The ECB overlooked again which impact its decision has on the foreign exchange and the commodity markets. As the euribor futures price in further rate hikes this year, the euro has strengthened in the foreign exchange market to almost 1.45 versus the US dollar despite Portugal became the third member country needing a bail-out. As our quantitative models show, a weaker US dollar is still a factor in the commodity markets that leads to rising prices. This had also been reflected in the energy and metal markets towards the end of last week. Normally, commodity prices rise in percentage terms more than the US dollar depreciates. Thus, the eurozone has to expect that prices of the inflation drivers will not come down but would increase further. The ECB would hike rates even more, behaving like a cat chasing the own tail.

Making a mistake is human and not a problem. However, making the same mistake several times is a shame. However, for investors in commodities, the ECB rate decision would very likely lead to further rising profits. Thus, thank you ECB for fuelling commodity price rallies as you did in 2008.