ECB appears eager to raise interest rates
The core Harmonised Index of Consumer Prices (HICP) rate, which excludes energy and unprocessed food, fell to 1.6%.
Thus, having been stuck at 2% or above for a number of years, core inflation has at last decelerated to well under 2%. The recent decline reflects two factors in particular. First, increases in administrative health charges in early 2004 have now dropped out of the annual rate. Second, clothing prices have declined recently.
Indirect tax hikes are contributing to high alcohol and tobacco price inflation, which is running at 7.2% in year-on-year terms. If these goods, which comprise just 4% of the HICP, are also excluded, then underlying core inflation is now running at just 1.3%.
Despite all this good news, it would appear that the ECB Governing Council is itching to raise official interest rates.
One should not be surprised by such a low inflation rate given the weakness of consumer spending and wage growth and the strength of the euro. As things stand, high oil prices are the main factor keeping headline inflation above 2%.
However, even if oil prices stay around their current high levels, the impact on the inflation rate will diminish over the course of the year because of base effects. Inflation would eventually fall to around 1.5% in these circumstances.
However, ECB President Jean-Claude Trichet told the European Parliament recently that "it is absolutely clear that the risks to inflation are on the upside."
Nonetheless, ECB staff forecasts are for HICP inflation to average 1.9% this year and 1.6% in 2006, down from 2.1% in 2004.
ECB officials continue to highlight the risks to price stability posed by excess liquidity and the consequent strong growth of monetary aggregates.
Indeed, in its March bulletin, the ECB published the results of a new leading indicator model of inflation that it complied using seven monetary indicators.
This model points to inflation moving within a 2-3% range between now and mid-2006. The article also eferred to the "possibly large impact of the low level of interest rates on monetary developments."
The ECB has held rates at 2% or zero in real terms for almost two years now. It seems to have become increasingly uncomfortable with the length of time that it has had to pitch rates at such low levels.
It believes that such a prolonged period of low rates is fuelling the accelerating growth of monetary aggregates, posing medium term risks to price stability. Thus, it would like to hike rates.
It has now an additional argument in the aftermath of the political compromise over the Stability and Growth Pact, which the ECB is seriously concerned about. The problem for the ECB is that the weak eurozone growth performance makes it very difficult to justify raising rates.
Indeed, recent weak inflation and real economic data provide a case for even lower interest rates.
However, the ECB has ruled this out.
Hence, the market is discounting a 0.25% rate hike in the third quarter, with the possibility of a further rate increase in the final quarter of 2005.
The ECB should not be talking about tightening policy in the current weak economic environment.
Talk of higher rates last year was derailed by the unexpected weakness of activity during the second half of the year. With the ECB now pointing to a readiness to raise rates, a modest pick up in growth in the first half of 2005 may be enough for the ECB to hike rates later this year.
Given the ECB's tightening bias, we stick with our forecast that the official refinancing rate will be hiked by 0.5% to 2.5% by the end of 2005.
John Beggs, chief economist, AIB Global Treasury.
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