European and British Central Banks Hold Interest Rates Steady...

Increasingly concerned language regarding inflation has continued from both the European Central Bank and the Bank of England in virtually every policy paper and governor's comment over the last few months. Accordingly, both institutions' decision today to keep interest rates steady, despite significant evidence of a broad-based slowdown in Europe, was hardly surprising.

This, of course, begs the question "why isn't the Federal Reserve as concerned about inflation?" With European short term rates at 4.75% and US rates at 2%, it would seem logical that the US would be more concerned that low borrowing costs are likely to be similarly inflationary; Presumably more so...

While there is certainly dissention among the ranks at the US Fed, the general view in American circles is that the recent declines in commodity prices are likely to have disinflationary effects. Clearly, despite negative real interest rates, yesterday's Beige Book revealed that credit conditions have tightened throughout the country. But, as the ECB's report today pointed out, this appears to be the case in Europe as well. So, why are the Europeans holding rates at a relatively high level, while the Americans are not?

Largely this can be attributed to the labor market differentials between Europe and the US. One of the reasons why recent US recessions have been so mild can be attributed to the relatively weak influence of labor. By and large inflation has helped keep in check by slow growth in wages and increased productivity. The recent increase in unit labor costs of just 0.6% (vs. inflation that averaging somewhere around 4%) is an example of the flexibility that employers enjoy when business slows down. This avoids creating a stagflationary situation where the economy slows and inflation doesn't abate because wages continue to rise.

This stands in contrast to the far more regulated and unionized economies of Western Europe, where wages are often required to be indexed to inflation. This is particularly frustrating when inflationary pressures may be temporary or caused by highly volatile factors (like energy and food prices). For this reason, the ECB's President Jean-Claude Trichet has made it abundantly clear that the reason they are holding such a strong line against what they agree are temporary inflationary factors - which they agree are likely to abate (i.e. oil prices) is because of fears that high rates of inflation will cause a wage-inflationary spiral (i.e. stagflation).

The Governing Council has repeatedly expressed its concern about the existence of schemes in which nominal wages are indexed to consumer prices. Such schemes involve the risk of upward shocks in inflation leading to a wage-price spiral, which would be detrimental to employment and competitiveness in the countries concerned. The Governing Council calls for these schemes to be abolished.

What Trichet is essentially saying is that the indexing of wages to inflation reduces the flexibility that he and his fellow governors enjoy in determining monetary policy.
For these reasons, I think that we need to view the ECB and US Federal Reserve's divergence in policy as a consequence of the labor environment that both must operate within, rather than caused by a belief that commodity prices are likely to continue inflating.