ESCUDO CONTRA A INFLAÇÃO

Inflation protection: one index doesn’t fit all
Ivo Arnold Jun 25, 2008

Will inflation spoil the ECB’s 10-year anniversary party?

While the ECB has succeeded in keeping inflation close to two percent for almost nine years since its inception, at the start of 2008 inflation crept above three percent and has remained there since. This level is clearly incompatible with the ECB’s price stability objective. Moreover, inflationary pressures from energy and food markets show few signs of abating. A prudent monetary policy response would focus on preempting second-round effects via wage formation and inflationary expectations. A firm interest rate hike by the ECB is, however, hampered by worries about financial sector fragility and the potential consequences of the credit crisis for the real economy.Uncertainty about the inflation outlook and the monetary policy response is reflected in the market for index-linked bonds. Demand for these bonds has surged this year, pushing so-called breakeven inflation rates to their highest level since years, as investors seek protection from soaring oil and commodity prices. Market participants complain about the limited supply of indexed linked bonds, which results in high prices and low real yields. In the euro area the supply is also of the wrong kind. Inflation protection predominantly comes in the form of plain-vanilla bonds indexed to a euro area consumer price index. These bonds are not tailored to the needs of users based in individual countries and fall short of offering full inflation protection. Nor do these bonds have very attractive diversification properties. If European governments would issue more bonds linked to national inflation rates, investors would be better able to lock in real-value certainty and the bond market would be enriched by a varied supply of index-linked flavors.
Index-linked bonds (ILBs) exist because they benefit issuers as well as investors. (...)

(...)Is it really true that inflation uncertainty is still a national experience, ten years after monetary unification? After the introduction of the euro, the cross-country variation in the inflation rates has in any case not fallen quickly. Inflation differentials have also been quite persistent (much more so than in the United States). As a consequence, the consumer price indices of euro area countries have fanned out and seem to bend together only slowly, if at all (see the graph).

Over the period 1998-2007 the purchasing power of €1000 has diminished from €858 in Germany to a low of €707 in Ireland. Even if over time inflation rates would converge to the euro area average, there is no guarantee that the accumulation of past inflation deviations will be compensated by opposite deviations in the years to come. In that sense, national inflation shocks still entail considerable long-run price-level uncertainty even if the inflation rates themselves would have a tendency to converge.
Price level divergence is much more of a problem in the euro area than in the United States, the latter being a better integrated currency union with greater price/wage flexibility and higher mobility of production factors. The persistence of euro area inflation differentials is exacerbated by the macroeconomic adjustment process. With a uniform nominal interest rate, domestic real interest rates will be lower in high inflation regions, discouraging savings and stimulating consumption and investment. Compared to a monetary policy that is conducted nationally via a Taylor-type interest rate rule, within a monetary union the real interest rate channel no longer acts as a brake on the cycle but instead may accelerate regional economic developments. This effect may be further amplified by wealth effects, as low real interest rates inflate housing prices (Spain and Ireland being the obvious examples here). The remaining countervailing force is the appreciation of the real exchange rate. However, the elimination of nominal exchange rates has reduced the speed with which this variable adjusts. This implies that a strong cross-country synchronization of inflation cycles cannot be taken for granted inside the euro area.
Inflation uncertainty is likely to be a bigger problem for smaller euro area countries. ECB interest rate setting is based on aggregate euro area data. Because of their low weight, inflation shocks in small countries have a minor effect on euro area data. Large countries have greater influence on ECB policy. While investors residing in small EMU countries are faced with increased inflation uncertainty, their hedging opportunities are currently inadequate. This suggests that there may be a demand for inflation-protected securities aimed at investors in individual countries.
The data illustrate the usefulness of nationally indexed ILBs in hedging inflation risk. Nationally indexed ILBs will also contribute more in terms of portfolio diversification than euro-indexed ILBs. If the safeguards in the Maastricht Treaty do their work, the ECB will be able to keep inflation close to 2%.

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