This is the second in a series of weekend comments on what I have learned in the past 7 days about the global economy and financial markets. This week, there has been a notable rise in inflation concerns as higher food and energy prices start to impact consumer prices. There have been signs that European governments are discussing a more comprehensive package to address the sovereign debt crisis. And China has continued down the path of gradual monetary tightening. Next week, Mr Hu visits Washington, Ecofin meets to discuss sovereign debt, and China publishes its macro data for December.
This week, I have learned that:
1. Inflation concerns are back on the agenda. Consumer price figures published on Friday showed 12-month headline inflation in the Eurozone rising to 2.2 per cent, while in the US it rose to 1.5 per cent. In both cases, higher energy prices were the main culprit. However, the response from policy makers on either side of the Atlantic was quite different. Jean Claude Trichet deliberately sounded hawkish at his press conference on Thursday, reminding everyone that the ECB had raised interest rates to control inflation in July 2008, when the world was on the brink of its deepest recession since the 1930s. The ECB President does not seem to share the widespread view that this was a mistake. In the US, on the other hand, noises emanating from the Fed remain dovish. 
Boston Fed President Eric Rosengren (admittedly a proven dove) said that higher energy prices were unlikely to feed through to underlying inflation, but would act as a tax on households and businesses which might weaken the economy and actually reduce core inflation. The first graph shows monthly annualised inflation, ex food and energy, smoothed to capture underlying trends. In the US, there is no sign of any rise in core inflation, which remains worryingly low. And although Eurozone inflation rates have risen slightly since mid 2010, the underlying rate remains below target. Nevertheless, the ECB is clearly beginning to think that unconventional monetary policy should end fairly soon, which raises complications for sovereign debt (see below).
2. The yield curve is extremely steep. Although I am not very worried about core inflation in the US, the bond market is showing signs of disagreeing. The inflation expectations built into the TIPS market have risen to 2.42 per cent now, compared to 1.47 per cent in August.
And the yield curve in the Treasury market (measured by the spread between 30 year and 2 year bond yields) is the steepest since at least the mid 1970s. A steep yield curve normally denotes very easy monetary policy, which is presumably why equities continue to rise. Until the Fed starts to worry sufficiently about inflation to tighten monetary policy, it is hard to see any of this this changing. (However, for those interested in technical models, equities are looking overbought in the near term, having hit new highs last week. These models suggest caution in the short term.)
3. China continues its progressive monetary policy tightening. Because food and energy prices have a much higher weight in China than in the developed economies, inflation concerns are more urgent in that economy than in the West. In recent weeks, monetary growth and bank lending have remained higher than the authorities feel comfortable with, so they have announced another 0.5 per cent increase in reserve requirements. This is in part an attempt to mop up the excess liquidity created by the foreign exchange intervention needed to hold the yuan down. Meanwhile China is also trying to relax capital controls to promote the development of the yuan as an international currency. Macro-economists frequently remind politicians about the “impossible trinity”, which holds that countries cannot simultaneously enjoy the freedom to change domestic monetary policy while also fixing the exchange rate and permitting free capital movements. This week in Washington, Mr Hu will be told to solve this conundrum by allowing the yuan to rise more rapidly. He is doing so, gradually.
4. European governments are debating a solution to the sovereign debt crisis. The ECB is itching to return to a more normal monetary policy, which implies less official help for the banks in Ireland and Spain, and smaller purchases of bonds in the secondary market. But if the ECB withdraws its support, will this not simply trigger a much bigger crisis in the troubled sovereign debt markets, including Spain? That would be the risk, unless eurozone governments step up their existing support package, which is what the ECB and the Commission are now urging them to do. The German and French finance ministers have suggested that they may be willing to increase the size of the EFSF, as noted in this previous blog. Mrs Merkel said yesterday that any new proposals must be part of a comprehensive reform package, presumably including a new mechanism for dealing with future debt crises, which is surely sensible. For the first time since Greece hit trouble last May, a compromise to get ahead of market sentiment might just emerge. This will be a major theme in next week’s Ecofin meeting, and the European Council in February.
5. Hollywood hates Wall Street – and Harvard. Courtesy of the FT and Pi Capital, I have been able to see an advance copy of the film “Inside Job” prior to its release in Europe. Apparently, it has already been seen by a million people in the US. Made by Charles Ferguson, it is a documentary which suggests that the credit crunch was caused by a massive conspiracy of evil and greedy people, including many or all of those in office in Washington, Wall Street, the regulators and academia. The movie is compelling in its way, and some of the criticism levelled at parts of the financial industry is clearly valid. But, if you see it, please remember that this documentary would never have been passed by the editorial process at the BBC, or the FT for that matter. Impartial it was not.
