Does Trichet Understand Inflation? UPDATED

The Wall Street Journal reports:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent’s debt crisis.

In my previous post, I demonstrated that there is reason to believe that tight monetary policy by the ECB can potentially explain the downturn in the Eurozone and, potentially, the drastic declines on the periphery like Ireland. This performance is worse when coupled with the fact that the ECB strongly encouraged the Irish to prevent bank failures providing temporary liquidity and then laying the problem at the feet of the Irish taxpayer when it turned out that the problem was worse than previously imagined.

Nonetheless, putting past performance aside, the ECB is now fearful of inflation. Unfortunately for those in the Eurozone, it is not clear to me from the article that the ECB understands inflation. For example, consider the following excerpt:

In an interview with The Wall Street Journal ahead of this week’s annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don’t gain a foothold in the global economy.

So far, so good. Rising energy and food prices might be signs of inflationary pressures. However, this is the following paragraph:

Mr. Trichet’s warning comes at a time when inflation concerns are mounting among investors around the world. Fast-growing emerging markets such as China and Brazil are seeing rising inflation at home, and their demand for globally traded commodities is pushing prices higher elsewhere.

So which is it? Are prices rising because of increased demand in Brazil and China or because of inflation? It cannot be both. If prices of globally traded commodities are rising, it could be a sign of inflation, but it could simply be a relative price adjustment — even if it is a sustained relative price adjustment. In other words, rising commodity prices are a potential sign of inflation, not the cause of inflation. There is a difference between arithmetic and economics.

Nonetheless, it could be sloppy reporting by the WSJ, except that it is not. Here is Trichet:

“All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects” on domestic prices, said Mr. Trichet in his office overlooking Frankfurt’s financial district.

And here are the WSJ reporters:

Changes in food and energy prices are largely determined on world markets, and thus aren’t directly influenced by interest rates in any one economy. For that reason, central banks in many major economies, including the U.S., put greater weight on core inflation than on headline measures. For now, Fed officials don’t see much evidence that commodity prices are feeding broader inflation in the U.S.

The WSJ reporters clearly recognize the difference between relative price adjustments and inflation. So what does Trichet really believe? Does he believe that by raising interest rates in the Eurozone that he can reduce the demand for globally traded commodities in Brazil and China? Or, is he simply just trying to anchor inflation expectations? For everybody’s sake, I hope it is the latter.

UPDATE: Kantoos uses German inflation indexed bonds to calculate a TIPS spread of expected inflation in the Eurozone. Using these calculations inflation is expected to remain below 2% over the next 5 years and even below 1.5% over the next 2 years.

7 responses to “Does Trichet Understand Inflation? UPDATED

  1. Pingback: Trichet, “o obcecado” « Historinhas

  2. Pingback: Was ist Trichet Definition von „Inflation“? « Kantoos Economics

  3. Pingback: Rebecca Wilder on Eurozone monetary policy and German inflation « Kantoos Economics

  4. The above article looks not right to me. It incorrect that relative price adjustments have nothing to do with inflation, or rather that one can make a clear-cut distinction between the two. If prices for 99 percent of the consumer bundle adjust upward relative to 1 percent, this is inflation. The question thus is whether the prices that adjust adjust up or down, and what share the prices that move up have in the consumption bundle.

    In this case, commodities adjust upwards, and their share in the consumption bundle is large, thus they trigger a higher CPI and therefore inflation.

    Now commodity prices are often taken out of the CPI for monetary policy purposes because they are volatile, send more noise than signal. But in this case there is a broad-based and persisent increase in commodity prices, thus it would seem incorrect to ignore this.

    Overall I believe Trichet’s attitude towards this is correct: if this surge affects inflation expectations and wages, moneary policy has to act.

  5. hkaspar,

    I think that either you have misunderstood my point or I have communicated it poorly. I did not mean to imply that inflation does not result in relative price changes. Rather, my point is that the increase in commodity prices is being driven by foreign demand, not ECB monetary policy. As such, tightening policy will not help to alleviate upward pressure on commodity prices.

    As I stated at the end of the post, however, it is my hope that the threat of tightening coming from the ECB was meant to stabilize inflation expectations rather than implying that tighter policy could temper rising commodity prices. I believe the former is important.

  6. @ Josh

    OK, seems our differences are semantic rather than substantive.

    Cheers,
    HK

  7. Pingback: When Food Prices Attack!…Manning the trenches in Buenos Aires, Argentina… | Project World Awareness

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