In reality, consumer price inflation is far more likely to remain in line with the European Central Bank’s “close to but below 2 per cent” objective.
Inflation will largely be influenced by developments in energy prices and labour costs in the months ahead. Let us look at energy first. After contributing up to a full percentage point to the rate of inflation at times during 2006, energy is now adding virtually no inflationary pressure thanks to declining prices of oil and natural gas and a rise in the euro’s exchange rate. As a result, both the overall rate of inflation and the rate excluding energy almost converged in February, at 1.8 per cent and 1.9 per cent respectively. If oil prices and the underlying rate of inflation remain stable, headline inflation could fall perhaps as low as 1.5 per cent this summer.
Labour costs, the second major influence on inflation, are another matter. Companies’ profits have grown impressively and some trade unions are pressing for wage increases at a time when the European Commission’s survey of businesses indicates that skilled workers are in shortage and the euro zone’s 7.5 per cent unemployment rate is the lowest since the monetary union was formed. While these are valid inflation risks, we do not think wage pressures will lead to a marked increase in consumer price inflation.
What about the low unemployment rate and apparent shortage of skilled workers? Over the longer term, reduced barriers to labour movement within the euro zone will help cap wage increases and ease pressure on the labour market.
In sum, the rise in labour costs is likely to be modest, lifting core inflation from about 1.5 per cent currently, after factoring out Germany’s VAT hike, to about 1.75 per cent by early 2008. Headline inflation will depend on energy prices, but it would take oil prices back above €54 per barrel to cause an inflation problem for the ECB. Signs of weaker growth in Italy, France and the US also suggest future inflationary pressure is waning.
All this leads us to conclude that the ECB should leave rates on hold at 3.75 per cent rather than continue to raise rates as the market expects. This has implications for the yield curve. When the ECB shifted from hiking to going on hold in the past, the yield curve steepened in anticipation of the easing cycle. When the next easing cycle eventually occurs, possibly in early 2008, today’s flat yield curve will steepen again too.
Andrew Bosomworth, portfolio manager and head of European money market and derivatives team at Pimco.
