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Balancing monetary policy

01 June 2018

How will the ECB balance monetary policy in light of higher inflation and heightened political risk in the periphery of the Eurozone?

It is the mandate of the European Central Bank ("ECB") to control monetary policy, with the target of achieving an inflation objective of below but close to the 2% level. This week, headline Eurozone inflation increased from 1.2% to 1.9% for May, comfortably above consensus forecasts of 1.6%. Whilst this pleasingly meets the ECB's target level, what was more significant was that core inflation (excluding food, energy, alcohol and tobacco) increased to an eight-month high of 1.1%.

The bounce in the headline level can be partially explained by the higher energy costs. However, the rise in core inflation indicates that price pressures in the Eurozone are firming up as the labour market continues to improve and growth becomes more entrenched in the region. The timing of May bank holidays also had a minor effect, notably on the price level of services in Germany.

Although the inflation objective is important, one must remember that policy is determined by one central bank for the whole Euro area. Considering the more fragmented political environment seen over the past decade, the ECB has shown that it will prioritise the survival of the currency bloc over meeting its longer-term objective. The ongoing political noise in Italy has brought back painful memories of the 2012 Eurozone debt crisis, as a more antagonistic Italian government is set to take the reins. While we have seen the extreme policy rumours being played down, the new populist coalition is likely to be at loggerheads with the EU over its budget rules. There have also been political developments in Spain, where Prime Minister Mariano Rajoy has been ousted via a vote of no confidence. However, it is worth noting that opinion polling in Spain indicates that there is not the flagrant anti-EU sentiment that one sees in Italy. 

Considering the wider risks to the economy and to business confidence, the ECB is likely to prioritise stabilising concerns of the survival of the Eurozone rather than unwinding its accommodative monetary policy.  Although at the time of writing an Italian government has formed, it is too early to tell whether the Euro break-up fears will subside sufficiently to give the ECB the confidence to end its asset purchase programme over the coming year. We believe that core inflation is unlikely to significantly overshoot in the medium term; hence any delay in raising interest rates should not give the central bank too much grief at this time.


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