Will we get a rate reduction? Not if the ECB does it's job we won't.

Interest rates in IrelandI have seen articles in the news and economists from large lending institutions are saying they believe we will see two rate reductions in 2008. There are various reasons being put forward for this, and personally I would be delighted to see this happen, however, the flip-side is that if the ECB drop rates then to a degree they will just undermine their own credibility. Why? Because the ECB are not there to save the market just because there is a credit crisis, they were willing to inject liquidity in order to ensure that credit kept flowing, but in the area of Base Rates their only tenet is to control inflation at ‘near or just below 2%‘.

Rate reductions are inflationary, more money starts to move about the economy and there is an upward movement on prices, at the moment inflation is already above the stated target so cutting rates would only exacerbate that, if we get a rate cut two things will happen, firstly the ECB will have broken its raison de etre, and secondly there will be more inflation and that will only hurt markets even more.

If there is a rate cut it doesn’t mean property will recover, in fact it would probably make things worse, because inflation in every other aspect of the economy would increase and mean that there is less money to purchase property, the rising margins set by banks mean you can borrow less, and the result is that builders would have to chop prices in order to attract buyers, if there was ever to be intervention it should have been the ECB stopping property prices from the insane highs they reached.

agflation, commodiflation, biofuel farmerThe inflation we are seeing is commodiflation, and agflation, commodiflation is in commodities like oil and gold, expensive oil (record of $117 a barrel hit this week!) means it costs more to get food from out of the ground and onto supermarket shelves, and food is also being used to make energy in the form of bio-fuels, it seems that the hunger of petrol tanks worldwide is taking precedence over the hunger of its human inhabitants.

The increased price in foods is described as Agflation, and although part of that is driven by biofuels, and rising commodity/energy prices it’s also down to changing diets worldwide, nations with huge populations like India and China are moving towards more westernised ‘meat driven’ diets, any well versed vegetarian can tell you the difference between the yield on land in vegetables versus that of raising livestock.

In the past agflation happened from time to time, mostly due to weather cycles such as the 1972 Soviet (Ukraine used to be referred to as the ‘breadbasket of the Soviet Union) crop failure that lead to a doubling of wheat, corn, and rice prices. The current trend however is a mismatch of accelerated demand with things that are reducing supply, so consider it a double whammy.

ECB President: Jean Claude TrichetFood is also being driven to market highs by investors, as with any market there is normally a rush of investment on the way up and we are seeing that, via stocks of food companies and in the actual commodities market itself where traders are chalking up record profits, this move of money towards wheat/corn/rice etc. means that prices are rising as more demand is heaped on a finite supply. An inflationary move by the ECB, and that’s what a rate cut would boil down to, may be required and called for by industry but it certainly won’t help the wider economy, a liquidity injection would do more the EU at this point. If the inflation guideline is adhered to we may actually see a rate rise, but the slowing GDP will hopefully ease demand driven inflation and doing nothing may be the better solution.

So when you are in the shops next, you’ll see many ‘sale’ signs because retailers are being hit by the slowdown, however, you can fully expect your bill at the register of the supermarket to start creeping up, and the bad news is your mortgage will likely do the same as banks push margins to compensate for their own financial woes.

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