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The View from the Other Side

Market Directions Sunday June 15, 2008

The ECB’s Inflation Economics

Wages, wages, wages. If Jean Claude Trichet has never actually paraphrased the real estate cliché he certainly knows what it means. For the European Central Bank (ECB) the inflation fight has been all about preventing consumer inflation from becoming wage inflation. It is a fight the ECB may be losing.

In the first quarter of 2008 total labor costs in the Eurozone were 3.3% higher on the year; in the first quarter of 2007 the gain had been only 2.3%. The rise in labor expense was driven by wage costs which accelerated 1.3% over the year, moving from 2.4% in May of 2007 to 3.7% in May 2008.

In comparison the non-wage component of total labor costs gained only 0.4%, over the year, rising from 1.9% in the first quarter of 2007 to 2.3% in 2008. Labor costs, which are the largest portion of the price of any good or service, are being driven higher in the Eurozone by a rapid increase in salaries.

These wage costs are the “second round effects” of inflation that keep Jean Claude Trichet awake at night.

Long term union contracts tend to lock inflation expectations into the economy. Instead of responding to the changing inflation environment a multi-year contract assumes inflation rates for the life of the agreement. The rates are most often based on current inflation conditions. The natural tendency is to seek inflation protection for union members by erring on the side of caution, that is on the side of higher inflation.

A three year contract that incorporates a 2.5% wage increase per year is saying one of two things. Either, our workers are more productive, they produce more goods per unit of cost, therefore a rise in wages is justified. Or, prices will be 2.5% higher a year from now, our workers will need more money to retain their existing compensation level. Reality of course is a combination of the two effects. Workers are somewhat more productive as industry strives to find better and more efficient methods of production. And even in the best of times, inflation is never completely absent.

For the ECB the problem is that Eurozone productivity gains in most industries have not kept pace with wage increases. Unit labor costs have risen more than 3.0% in financial services in the past year and even more in the construction trades. These increases have been spurred by fear of rising inflation.

It might seem eminently fair that with inflation running at 3.6% in the Eurozone, almost twice the official target rate of 2.0%, workers and their unions would seek compensation in line with their actual increase in living costs. But the inflation situation is more complicated.

Because contracts are usually in force for several years and are often uniform across industries, the annual wage increase provides large groups of workers with more cash to spend. If that cash increase is based on productivity improvements there is little effect on inflation. Workers have more money to spend and there are more goods to buy. If however, the wage increase is inflation based, it can institutionalize inflation by providing more money to chase the same number of goods. This remains true even if the original cause of inflation subsides. In effect a temporary increase in prices from a commodity shock becomes ingrained in society’s inflation expectations through the wage mechanism, producing a permanently higher inflation rate in the economy.

It is the ECB belief that the current European inflation rate is a product of just such a transitory effect — the rapid rise in the price of oil. And there is more than a reasonable expectation that they are right.

The economics or at least the price effects of the crude oil market are visible to all. But the key historical factor in oil prices is their volatility. One year ago oil was trading at $65 a barrel, less than half its current price. A year hence it may not be $65, but it is a good bet that it will be lower than it is now. This is simple economics, often forgotten in the hue and cry over inflation. High prices for any good brings three things: new supplies; substitution and efficiency. All three inevitably reduce the price of the good. Oil may not return to $65 dollar a barrel by June 2009, (its price in May 2007) but barring a conflagration in the Middle East it will be below its current price.

In planning their long term economic forecasts and rate policy, ECB planners take a traditional approach to oil and commodity prices, the simple scenario outlined above.

Predictions of $200 oil prices notwithstanding, there is little in the current world economic situation to warrant such dire forecasts. The world is not running out of oil. Many of the constraints on oil exploration and production are, or were, cost related. Some restrictions on development are political. The cost factors have been obviated by the rise in oil prices. Oil reserves that were not profitable at $40 or $60 a barrel are suddenly very profitable at $90 or $120. Political restraints may or may not be removed by public pressure but the important fact is that they can be eliminated by a change in law. They are not inherent in the supply and demand equation. Sustained high oil prices will bring increased production from both sources: the marginally profitable fields and from previously off limits productive areas.

Oil and commodity prices have been the main cause of inflation volatility. In one year the Harmonized Index of Consumer Prices, (HICP) the uniform Eurozone measure of consumer inflation has risen from 1.9% in May 2007 to 3.6% in 2008.

The ECB uses the so called ‘headline inflation number’, which includes energy and food prices, for its inflation calculation. The American Federal Reserve prefers the ‘core inflation’ number, the inflation rate without energy and food prices.

For comparison, the US ‘headline inflation’ rate has risen from 2.7% to 4.2% since May 2007, but the core rate has barely budged. Last year it was 2.2%, this year is 2.3%. Similar disparities exist in Europe.

One can easily make the argument that since consumers have to pay the headline rate, the core rate is irrelevant. But when choosing which rate to use for multi year projections, or wage contracts, or central bank rate policy, the core rate is clearly not irrelevant. If oil prices retreat to considerably lower levels by next year, which, though not guaranteed, is certainly possible, a central bank that had based its rate policy solely on headline inflation would be out of step with the economy. If the bank had hiked rates to counter headline inflation, it would have probably caused far more economic pain than necessary.

This is the dilemma that is behind the ECB’s rather peculiar threat to hike rates once in July and no more -- once and only by a “small” amount. Since the standard ECB rate move has been 25 basis points, and that has never been called small, does “small” mean the hike will be less than 25 basis points?

The ECB is clearly determined to prevent the writing of price inflation into the Eurozone economy through wage inflation. But their rate threat is really no different than the recent Federal Reserve jawboning against inflation in the US. It is just that ECB spokesmen have remonstrated so often and so vehemently against inflation that they have no way to ratchet up their warnings except to threaten a rate increase. A ‘single small rate hike’ is just rhetoric by other means.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]


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