European rates too low to anchor inflation expectations, says Pimco

Pimco foresees more European rate hikes this year and says they are necessary to anchor inflation expectations, but cautions Europe’s Central Bank must also realise some nations “appear insolvent”.

Andrew Bosomworth, executive vice president at the fixed income specialists, praised the ECB’s track record in delivering price stability as “admirable”, but said its current official interest rate was “incompatible with anchoring inflation expectations”.

ECB president Jean Claude-Trichet continually referred back to the goal of anchoring expectations when he announced a 0.25% rate hike last week.

Bosomworth said: “Households’ price expectations are increasing and commodity prices are driving headline inflation higher.”

It would be too late to tighten policy once pressure on wages appeared, he said.

“From a financial stability perspective, a little tightening now may help nudge down commodity prices and avoid the next bubble.”

Bosomworth added the rate was inconsistent with “the recovery in economic growth”.

Even hiking to between 2% and 3% would be overly conservative, he said, in light of the fact Germany’s rate averaged 4.5% through various inflation conditions of the 1980s.

He said eurozone nominal GDP growth will be 3% to 5% next year, and the policy interest rate historically averaged 0.5% to 1% below that.

However, he also acknowledged the ECB’s hands are tied to a point by the eurozone’s weakened periphery.

Pimco is still not allocating there “as yields do not sufficiently compensate for the very real risk of default”.

But Bosomworth said Pimco could consider doing so if the EC and ECB “bail in the private sector to solve the sovereign crisis once and for all. So long as uncertainty persists, however, it will act as a big disincentive.”

Europe’s sovereign debt crisis will only end, in Pimco’s view, when the eurozone “erects a firewall between solvent and insolvent countries” and “addresses the overhangs of the insolvent countries and banks by principal reduction”.

Bosomworth said Pimco is confident no contagion will occur, if restructuring – as per policies to restore surpluses, boost growth and recapitalise banks – is controlled “as envisaged under the European Stability Mechanism”.

However, Bosomworth warned: “If uncertainty surrounding Greece, Ireland and Portugal persists there is a danger it drags Italy and Spain into similar debt traps. Europe has neither the will nor wallet to support all member states.”

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David Walker

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