The ECB has always had inflation, or more accurately the ‘control of inflation’ as its only guiding light. The ECB raised rates by 0.25% on the 3rd of July and now it is time to wait and watch, to see what they will do next. While we don’t possess a crystal ball what we can do is take a brief look at the world and how some market movements may shape the next meeting of the ECB.

We are (worldwide) in an inflationary environment, in Vietnam inflation is at 25%! The highest it has been since the Vietnam War. The government there is trying to stop the importation of gold, because the Vietnamese have surpassed both China and India in the levels of gold consumption, in the first quarter of 2008 they imported over 38 tonnes. Why is this happening, and what does it have to do with the ECB?

The ‘Dong‘ is a fiat currency that was born in 1978, after the war, the currency that existed prior to that the French Indochinese Piastre (which was as metal standard currency), the people who left Vietnam for the USA after the war found (to their devastation) that all of their paper money was worthless, however, the emigrants who had brought gold were infinitely better off, as gold is a universal money and in places where MasterCard is not accepted, gold will be. So in many parts of the world gold is the asset people turn to when fiat money is failing because it keeps a common value. Here is an interesting point, an ounce of silver would buy you 4 gallons of petrol in the USA in the 70’s, today you can buy roughly the same with the same amount, so is oil truly expensive or is currency more worthless?

The point of the above paragraph is that the bull run on gold is partly due to inflation protection demand, people are investing in it as a means to keep ‘real’ value while everything around us gets exorbitantly expensive. This doesn’t help the paper money people though, hence the ruling in Vietnam that bans the importation of gold. It’s not a far cry from what FDR was forced to do in the USA during the 30’s when gold ownership became illegal due to Executive Order #6102. This is a fairly forgotten piece of US history. FDR also devalued the gold backing on dollars, in effect revaluing gold from $20 an ounce to $35 an ounce.

Watching gold is always a way to watch inflation, when gold prices spike generally it’s because paper money has changed rather than gold itself undergoing any change, so we can readily accept that inflation is on the up.

Energy and food are both running at the highest prices they have seen in twenty years, and in some cases we are seeing historic highs, points that have never been reached. Energy and food are not part of core inflation, however, that doesn’t mean it has no effect on core inflation because if prices in food and energy stay high for long enough they find their way into the core economy, this then puts a strain on wages and is often the cause of unions looking for higher wages, if that happens we get ’embedded’ inflation and this can lead to the situation we last saw in the 70’s which is ‘stagflation’.

Without going too far into the future (I believe that oil will reach records in 2008 and then crash at some point in 2009, because of the speed of markets I don’t see oil keeping a five year high or more the way we did in the 70’s) we can quickly determine that the ECB don’t really have much of a choice when it comes to rates.

Imagine if you were given nothing more than a hammer and told to go ‘build Rome’, well, the ECB have one hammer to work with, and they can choose to not use it (leave rates unchanged), or they can use it and raise rates or lower rates. Given the inflationary environment the ECB will, if inflation doesn’t come into check, raise rates at the next meeting, at best we will see rates unchanged. The ECB might not raise rates in order to see what effect the July rate raise has had, it does take time for interest rates to penetrate the economy, however, if we see short term inflation continue unabated then the rates will have to go up. I think that Trichet and the board at the ECB will aim to control inflation even at the expense of the wider economy and for that reason another rate hike is likely.

If we don’t see a rate hike we’ll see no change and then one of two futures, inflation continues so we’ll get no change then a hike, or we’ll see inflation come down as the global economy slows down and we’ll see stagnant rates until such time as inflation drops at which point (because the momentum of the economy would be downward in this scenario) we may witness stimulative moves (rate drops).