Thursday, April 12, 2012

The EU's Dilemma

Last week, the head of the European Central Bank gave a press conference.  I want to focus on his opening statements to paint a general picture of the EU right now.
Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. The information that has become available since the beginning of March broadly confirms our previous assessment. Inflation rates are likely to stay above 2% in 2012, with upside risks prevailing. Over the policy-relevant horizon, we expect price developments to remain in line with price stability. Consistent with this picture, the underlying pace of monetary expansion remains subdued. Survey indicators for economic growth have broadly stabilised at low levels in the early months of 2012, and a moderate recovery in activity is expected in the course of the year. The economic outlook remains subject to downside risks.

Medium-term inflation expectations for the euro area economy must continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Over the last few months we have implemented both standard and non-standard monetary policy measures. This combination of measures has contributed to a stabilisation in the financial environment and an improvement in the transmission of our monetary policy. We need to carefully monitor further developments. It is also important to keep in mind that all our non-standard monetary policy measures are temporary in nature and that all the necessary tools are available to address upside risks to medium-term price stability in a firm and timely manner.
The ECB is facing two, inter-related problems.  The first is inflation.   Here is a chart of the annual change in CPI for the euro area:

For a more complete picture of the EU area's inflation situation, see this inflation site on Eurostat.  However, this shows that inflation is one side of the EU's problem.

The second is economic growth.  Here is ECB president Draghi:
Let me now explain our assessment in greater detail, starting with the economic analysis. Real GDP contracted by 0.3% in the euro area in the fourth quarter of 2011. Survey data confirm a stabilisation in economic activity at a low level in early 2012. We continue to expect the euro area economy to recover gradually in the course of the year. The outlook for economic activity should be supported by foreign demand, the very low short-term interest rates in the euro area, and all the measures taken to foster the proper functioning of the euro area economy. However, the remaining tensions in euro area sovereign debt markets and their impact on credit conditions, as well as the process of balance sheet adjustment in the financial and non-financial sectors and high unemployment in parts of the euro area, are expected to continue to dampen the underlying growth momentum.

The above two charts show the other half of Draghi's problems.  Last quarter, EU growth contracted (the top chart).  This lead to an increase in unemployment (the bottom chart).  Ideally, the central bank would lower interest rates to spur lending growth as the primary way to deal with this situation.  However, rates are already at 1% and inflation is a threat.  Put another way, the ECB is between an economic rock and hard place from which there is no easy policy response.

Regarding inflation, Draghi stated the following:
Euro area annual HICP inflation was 2.6% in March 2012, according to Eurostat’s flash estimate, after 2.7% in the previous three months. Inflation is likely to stay above 2% in 2012, mainly owing to recent increases in energy prices, as well as recently announced rises in indirect taxes. On the basis of current futures prices for commodities, annual inflation rates should fall below 2% again in early 2013. In this context, we will pay particular attention to any signs of pass-through from higher energy prices to wages, profits and general price-setting. However, looking ahead, in an environment of modest growth in the euro area and well-anchored long-term inflation expectations, underlying price pressures should remain limited.
Or, "the only cure for high commodity prices is high commodity prices."  Draghi is hoping that high energy prices will stave off demand of energy products, thereby lowering energy prices.  Frankly, it's about his only option at this point.