ECB President Trichet remained hawkish in comments today, noting that inflation is persistently above the target of just below 2%. Yet ECB monetary policy is not base don one pillar but two. The other pillar is money supply. Money supply measured by M3 rose 2% year-over-year in Feb. The ECB’s reference rate is 4.5%. This is to say that money supply in the euro zone is less than half the ECB’s reference rate and not validating the price pressures, which seem to be emanating largely from commodity prices. Headline inflation was 2.4% in Feb, while the core rate stood at 1%.
One need not be a strict monetarist to appreciate that money supply in the euro zone is growing too slowly to provide the necessary fuel for sustained higher prices. In fact, the 3-month annualized rate, which is sometimes used to smooth out some volatility, rose a 1.7% pace in the 3-months through Feb, the same pace as the previous three month period.
Nevertheless, the fact on the ground is that the ECB is going to hike rates. Although Trichet says the ECB does not pre-commit, the failure to raise rates at the April 7 meeting would likely be disruptive. The tightening of monetary policy and the strength of the euro, we think, can do little but exacerbate the pressure in the periphery. Although the periphery is a relatively small part of the euro zone GDP, the potential contagion and political fallout still needs to be reckoned with.
Many pundits ask where the euro would be if it weren’t for the peripheral crisis. We wonder where the euro would be if the Fed was pursuing only accommodative monetary policy and not extraordinarily easy policy.