A Sound Target?

The overall target-inflation rate of 2% aimed at by the ECB was hit some ago in the middle of Q3 2006 but this has not deterred the ECB of raising once in December 2006 and probably doing it again come March this year. And since inflation, helped by a dropping headline, now is well within the comfort zone the ECB still seems persistent in the aspiration to continue the process of interest rate normalization. But why? Well, one thing here is indeed inflation and more specifically the expectations on future inflation pressures from wage negotiations in Germany, but strangely it also seems as if the VAT increase has been tied somewhat to an increase in inflation, an assumption which does not seem to be supported by facts. A second point is the money supply and liquidity as measured by the broad-based monetary indicators (M3) and here the ECB is able to find ample justification for the continuation of the interest hike process.

The European Central Bank’s case for further eurozone interest rate rises was strengthened significantly on Friday by record growth in money supply data it regards as important inflation indicators.

M3, the broad money supply measure watched closely by the ECB, grew at an annual rate of 9.7 per cent in December, up from 9.3 per cent in November and the fastest since the launch of the euro in 1999. “After seeing a decrease in external price pressure, internal price pressures may be stronger,” Axel Weber, president of Germany’s Bundesbank and ECB governing council member, said in Davos, Switzerland.

So money supply growth remains strong but there are also signs that Q1 2007 might see a considerable slowdown on the  back of fiscal tightening and well a hawkish interest rate outlook. In Germany it seems that the VAT hike is transmitting iself more or less as expected with consumer and business confidence dipping. In Italy, the signs are the same as consumer confidence fell in January on the back of interest rate outlook and fiscal tightening. All this also seemed to have spilled over into France where business confidence dimmed on the back of the negative signals transmitted by Germany as well as the general dull economic mood in France ever since the suprising Q3 2006 slowdown. So where are we going from now? Over at MS Eric Chaney argues that a correction is on the table but not a downturn which again won't cause the ECB to stray from its tracks. I am inclined to believe him on the ECB but as a result also inclined to disagree with him on the forecast of a mere downturn. Especially Italy and Germany will be important to watch as we move forward I think and in(de)flation as well. I cannot by far predict a downturn with a straight face but neither can I totally deny the risk, so indeed we will see just how far down the Eurozone goes in Q1 2007 and beyond. One thing which is comforting though is that the US in all probability won't fall into recession which should bode well for exports in Europe also mirrored in the recent re-assertation of the Dollar vis-à-vis the Euro.