The wrong kind of Inflation

The past decade has seen inflation in the euro area average just 1.1% a year (the Irish figure is even lower, at 0.6%) which one might think was close enough to stable prices to satisfy the ECB’s mandate as set out in its statutes. However, an annual inflation rate ‘below 2%’ was initially set as a target by the ECB, then modified to the curious ‘ below but close to 2%’ and recently changed again to a flat 2%. The evidence would indicate that the Bank can neither control nor indeed forecast inflation with any degree of accuracy, although it would argue the counter factual-that inflation would be lower in the absence of its monetary policy measures- albeit based on the same models that have consistently over-predicted inflation in the past.

Forecast inflation remains a cornerstone of the ECB’s monetary stance, nonetheless, and its updated forward guidance sets out three conditions required before any upward move in interest rates. The first is that inflation should reach 2% well ahead of the forecast horizon. The second is that inflation is expected to remain there ‘durably’ for the rest of the projection period while a third requires that the outlook for core inflation also be consistent with a headline rate of 2% in the medium term.

Has the re-opening of economies this year precipitated any change in this disinflationary picture? In the short term the answer is yes as EA inflation has accelerated strongly in recent months and is currently at 3%, with a higher figure widely expected near term. On the face of it then one of the three ECB conditions for tighter policy has been met but forecast inflation in 2023 in their latest projections is still far below target , at 1.5%, Clearly, then, we have the wrong kind of inflation as far as the ECB is concerned. Higher oil prices are certainly a factor, but excluding energy EA inflation jumped to 1.7% in August. The reversal of the VAT cut in Germany in 2020 is also seen as factor, although inflation is above 2% in 15 of the 19 euro members, implying a broader driver, which the ECB identifies as ‘cost pressures that stem from temporary shortages of materials and equipment’. Base effects stemming from price falls last year are also important and in a recent presentation Isabel Schnabel, an Executive Board member,included a chart with inflation measured as the change in prices over two years, so removing the Lockdown year of 2020 from the picture.

Prices can rise from either an increase in demand or a fall in supply and the ECB clearly believes the latter is at play, with the impact fading next year. That may not be the case but it is striking how little inflationary pressures the Bank perceives as existing over the next few years, despite cumulative GDP growth of 12% in 2021-23. Indeed, in an alternative scenario , with growth at a cumulative 14% ,headline inflation is still well below target in 2023 , at 1.7%.

String GDP growth does drive down unemployment in the forecasts, with an UR rate falling to 7.3% in 2023 from 7.9% this year in their benchmark case. Despite this, wage growth is seen to slow, to 2.5% from 3.5%, so labour costs remain benign, as in pre-pandemic forecasts. Market expectations on inflation in the longer term have moved higher although still well below 2% and while longer term rates have also risen of late they are still consistent with negative policy rates for another 5 years, so investors would seem to broadly share the ECB view that nothing much has fundamentally changed in term of inflation.Given the reports of wide- scale labour shortages in some industries it may well be the ECB wage assumption that proves wrong if inflation does not ease as Frankfurt and the market expects.