Quite a few parallels are being drawn between the current situation with food and energy prices and that being seen in 2008. Food prices, looking in absolute but general terms (i.e. the Economist index) are now higher than was the case back then. Food price inflation isn't as high, but is certainly moving up.

For policy makers, the risks are similar. Should central banks focus on the inflationary threat, or look to accommodate the push higher in headline inflation, on the basis that more often than not these things come out in the wash? Furthermore, there is the impact on the economy to consider, with higher prices acting in many ways the same as tax on consumption, leaving less money to spend on the other essentials and non-essentials. The ECB finds it less easy to take the relaxed view. For starters, its price-stability reference is headline inflation, vs. the Fed's focus on core measures. Furthermore, the statistical evidence also supports the Fed's more relaxed stance, with the pass-through from headline inflation volatility to core prices lower in the US than both eurozone and the UK.

The ECB chose to put rates up in July 2008 on the basis of inflation moving higher. However, this move was reversed a mere three months later, soon after Lehman's had gone to the wall. Naturally, we're not (well, hopefully not) in the same position now in terms of such a high-impact event coming to pass, but there are still considerable underlying risks, most notable the situation in the Middle East and, more specifically, that it causes a further substantial push higher in oil prices.

In the early part of last year the ECB pledged to pull back from its plan to supply markets with unlimited liquidity at its various repos. The sovereign debt crisis soon put a stop to that, with the ECB again to perform an about-turn to ensure confidence was maintained within the banking system. It is keen to try the same again and may start to do so at this week's meeting. There are certainly signs that conditions in the eurozone money market have improved. The amount of excess liquidity around (money parked at the ECB over and above what banks need to meet reserve requirements), has fallen substantially, although not back to levels that could be described as normal.

Unfortunately only time will tell, but the risk of another about-turn from the ECB, either on liquidity provision, having to scale back its previous hawkishness or even reverse any eventual tightening, is a risk that should be carefully considered.

Simon Smith
s.smith@fxpro.com
+44 (0)20 7776 9725

Disclaimer: This material is considered as a marketing communication and does not contain and should not be construed as containing investment advice or an investment recommendation, or, an offer of or solicitation for any transactions in financial instruments. Past performance does not guarantee or predict future performance. FxPro does not take into account your personal investment objectives or financial situation and makes no representation, and assumes no liability to the accuracy or completeness of the information provided, nor for any loss arising from any investment based on a recommendation, forecast or other information supplied from any employee of FxPro, third party, or otherwise. This material has not been prepared in accordance with legal requirements promoting the independence of investment research, and it is not subject to any prohibition on dealing ahead of the dissemination of investment research. All expressions of opinion are subject to change without notice. Any opinions made may be personal to the author and may not reflect the opinions of FxPro. This communication must not be reproduced or further distributed without prior permission of FxPro.

Risk Warning: CFDs, which are leveraged products, incur a high level of risk and can result in the loss of all your invested capital. Therefore, CFDs may not be suitable for all investors. You should not risk more than you are prepared to lose. Before deciding to trade, please ensure you understand the risks involved and take into account your level of experience. Seek independent advice if necessary.

FxPro Financial Services Ltd is authorised and regulated by the CySEC (licence no. 078/07). FxPro Financial Services, Karyatidon 1, Ypsonas, Limassol 4180 Cyprus.