Inflation hawks sharpen their claws

Date: 30/09/1999

As the 'green shoots' of economic recovery sprout in the euro zone, speculation is rife that interest rates will rise soon. But the European Central Bank is unlikely to act for some time yet. Tim Jones explains why

THE nine-month-long propaganda nightmare endured by the euro area's economic policy witch-doctors may be over.

Bit by bit, the fabled 'green shoots' of recovery are sprouting in corners of the €6-trillion euro-zone economy which have until now been immune from the catalytic effects of the lowest interest rates in post-war European history, stable prices and labour law reform.

Italy - the single currency area's most sluggish performer to date - generated 84,000 jobs between April and June, with the bulk appearing in construction and services. French summer-month household consumption was up 5.3% on last year's levels and the much-watched IFO index of German economic confidence is heralding future growth.

It does not take much to get inflation hawks sharpening their claws. As the European Central Bank's governing council prepares to meet next Thursday (7 October), there is already talk in the financial markets that interest rates may soon have to rise as a 'pre-emptive strike' against a runaway recovery.

After all, the Bank of England has just raised rates by a quarter of a percentage point on very early signs of overheating in the British economy and ECB Vice-President Christian Noyer warned only this week that "some sort of action" would have to be taken to protect price stability in the euro zone.

As evidence, those who believe an interest rate rise is on the cards cite the ECB's favoured indicator of impending consumer price inflation; a pool of the more liquid forms of money known as M3.

This measure of broad money supply expanded by 5.6% in July compared with the same month last year - the fastest annual growth rate since monetary union got underway in January and 0.3 of a percentage point above the June rate.

The bank prefers the annual rate to be around 4.5%. ECB economists warned in their September bulletin that M3 was "moving away" from its 'reference value' while the 12-month growth rate for credit to the private sector remained "high" at more than 10%.

The ECB also pointed to a doubling of the seasonally adjusted one-month rise in M3 to 0.6% in July from 0.3% in June, identifying a strong increase in cash in circulation and overnight deposits as the main culprits.

Another ingredient could soon be thrown into this heady brew. Commodity prices appear to have ended their long downward spiral, with oil now fetching more than $23 a barrel and all the signs pointing upwards.

Although the euro zone's harmonised consumer price index rose by just 1.1% in July compared with a year ago, early inflation data from four German states showed prices rising by up to 1.1% in July alone in the single currency area's biggest economy.

Nevertheless, the ECB is unlikely to act for some time yet. For a start, much as the Eurotower's former Bundesbankers would love M3 to become as 'reliable' a policy guide to the ECB as it was to them, it is not yet.

Even money-supply targeting's greatest advocates admit that changes to investor behaviour brought about by the creation of monetary union itself has probably distorted M3 data. It is no coincidence that the bank set 4.5% annual M3 growth as a reference value and not a target.

Moreover, while annual credit growth is high, it fell to 10.4% in July from 10.9% in June. Many market participants also suspect that the expansion of notes and coins in circulation and easily-cashed deposits in July has as much to do with a stampede out of the bond market and worries that the millenium bug will cause chaos in the banking system on 1 January 2000 as with any kind of incipient consumer boom.

"A rate hike will not come until next year," says Michael Schubert, an ECB-watcher at Commerzbank in Frankfurt. "Although the money supply figures are up, when you look at them seasonally adjusted, the ECB could be comfortable that there is no acceleration going on."

Evidence of a continued deflationary bias abounds. The bank itself is forecasting that gross domestic product in the euro zone will grow by just 2% this year, rising to 2.75% in 2000 - hardly the stuff inflationary booms are made of.

ECB chief economist Otmar Issing, a leading hawk, has also acknowledged the "remarkable" fall in utilities prices brought about by EU-wide deregulation.

Even the signs of recovery in Germany and Italy - which represent half the euro-zone economy between them - are not all one-way.

Italian industrial output rose by just 0.5% between June and July, when independent analysts were predicting up to 2.4% month-on-month growth. Worse still, orders for Italian goods placed by foreign buyers were actually down on the month.

Germany's long economic twilight continues. The Federation of German Banks forecasts that even if GDP growth accelerates to 2% in the final months of this year, the average for 1999 will be a mere 1.5%.

As his popularity continues to plummet, Chancellor Gerhard Schroder will be sorely tempted to trim the controversial 14-billion-euro package of spending cuts he is driving through parliament and rely on anaemic economic growth to do half the job for him.

Apart from the real-estate tigers (Ireland, the Netherlands and Spain) the brightest spot in the euro zone currently has to be France. So often written off by the Anglo-Saxon press as hopeless economic causes, the French are now laughing once again.

Unemployment may still represent 11% of the workforce but private employment growth and the balance of payments surplus exceeds the euro-zone average, inflation is among the lowest and corporate investment is soaring.

The economic upturn has allowed the Socialist government to escape another round of budgetary austerity to meet its EMU commitment to keeping the budget deficit below 3% of GDP.

The newly agreed 2000 budget predicts that the deficit will narrow from 2.2% of GDP this year to 1.8% next; a performance largely predicated on strong growth and reduced interest payments on old public-sector debt.

The European Commission will undoubtedly criticise Paris for insufficient ambition when it analyses the government's budgetary performance in its biannual scrutiny of whether countries are complying with the terms of the stability pact, which is designed to ensure budgetary discipline in the euro zone.

Member states are supposed to keep their government finances "close to balance" in good times to avoid hitting the 3%-of-GDP ceiling the moment the unexpected happens - and recently announced budgets from the Netherlands and Spain have done just that.

The French government's current spending, on the other hand, is still partly financed by borrowing on the capital markets - a violation of the Maastricht Treaty's 'golden rule' for public finances.

The 2000 budget only lops 0.1% off the structural budget deficit but Finance Minister Dominique Strauss-Kahn will undoubtedly get away with it, while his German counterpart Hans Eichel will drive his party through political hell to get his spending cuts through parliament.

Schroder may have hardly noticed it given his political troubles at home, but the short-term prospects for euroland are rosier than anyone could possibly have imagined six months ago.

In their regular Euroland View, ABN AMRO Bank economists are predicting GDP growth of 2% this year and 2.9% next, with the euro-zone budget deficit narrowing to 1.9% of GDP this year and 1.5% next. The euro itself is beginning to stir, and looks likelier to approach $1.10 than parity.

This may not match the US' economic performance, but it easily avoids the nightmare scenario predicted by many in the spring.

The ECB should have plenty of time to refine its maths and employ a barrage of mass psychologists to work out what the new-style of euroland investor thinks and feels.

The Frankfurt bankers are likely to fly on autopilot for at least the next four months.

Major feature. As the 'green shoots' of economic recovery sprout in the euro zone, speculation is rife that interest rates will rise soon. But the European Central Bank is unlikely to act for some time yet.