Wednesday, March 31, 2010

Is Eurozone inflation about to become an issue?

Eurostat today released a flash estimate of Eurozone inflation for March.  They estimate the annual rate of inflation to be 1.5% – a big jump from the 0.9% rate recorded in February.

Eurozone InflationFrom an Irish perspective the important thing is not necessarily the factors that determine the rate as we are a small proportion of the Eurozone (<2%).  Rather the issue is the impact the rate has on ECB interest rate policy.

The ‘price stability’ target of the ECB is measured with an inflation rate of ‘about 2%’ (shown by the red line in the graph).  We can see that for 2005, 2006 and most of 2007 the inflation rate stayed very close to this target.  This was achieved through of set of interest rate increases beginning in December 2005 which say the ECB rate increase from 2.00% to 4.00%. 

In mid-2007 the inflation rate went about the 2% target.  This prompted a further rate increase of 0.25% to 4.25% in July 2008 when the inflation rate was above 4%.  This move was met with widespread criticism as the ‘Global Financial Crisis’ was in flow and the inflation rate quickly plummeted, even turning negative for a time in mid-2009.

The ECB responded with large cuts in interest rates and by May 2009 their key rate was at a record low of 1.00%.  It remains at this level.

As we can see the inflation rate for the Eurozone is showing a trend that may bring it back up to the 2% target.  This may accelerate the ECB’s desire to increase rates.

With the Irish economy still in the grip of the recession and many struggling to make repayments on loans and mortgages, an increase in interest rates is not what we want to see.

Of course, this is not the first time that ECB interest rates will not have been suitable for Ireland. See here.

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