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Ignoring the usual spring volatility, underlying inflation in
the eurozone has remained stuck at around 1%, confounding the ECB's
long-standing expectation of a pick-up.
Growth rates in compensation and unit labour costs have
accelerated but this has led to compressed profit margins rather
than higher core inflation rates.
With an eye on Japan's experience, the ECB has been aiming to
achieve a large "buffer" to ward off potential deflationary risks
during a subsequent downturn.
Its inability to achieve that objective is a worry, given the
maturity of the current economic expansion and an abundance of
risks.
The period from March to June is often characterised by
exceptionally high volatility in HICP inflation rates in the
eurozone due to seasonal distortions. This year has been no
exception. Look through the noise, however, and the core inflation
rate has been stuck at around 1% for the best part of two years,
continually undershooting the ECB's "below but close to 2%" goal
(see first chart).
The ECB has been expecting the sharp pick-up in compensation and
unit labour cost growth rates (both have been increasing by over 2%
y/y in the past few quarters) to filter through to higher core
inflation. But this has not been happening and the pattern of ECB
forecasts of core inflation having to be repeatedly revised
downwards has continued (see second chart).
The ECB initially ascribed the lack of pass-through to lags but
as the acceleration in unit labour cost growth has been evident
since late 2017, it is clearly more than that. The squeeze on
profit margins has proven very persistent and while firms would
like to rebuild their margins, they are reluctant to do so in the
current sluggish economic environment for fear of losing market
share. We have assumed in our baseline forecast a modest and
gradual pass-through from prior gains in labour costs into core
inflation during 2020 and 2021. But the risks increasingly look
skewed to the downside.
In the period after the eurozone crisis, from 2013 to 2016, the
ECB was rightly anxious about the threat of a debt-deflation trap
emerging. Those concerns faded as the stream of policy stimulus
boosted economic growth and the output gap narrowed. But the
inflationary "buffer" which the ECB was hoping to generate ahead of
a subsequent downturn has proved elusive.
A reprise of the ECB's analysis on this issue in the post-crisis
years highlights multiple concerns associated with low inflation.
One is that it complicates relative price adjustments between
eurozone member states. In other words, in the absence of higher
inflation rates in the hitherto more competitive countries (e.g.
Germany), those seeking to improve their relative competitiveness
are more susceptible to deflation, which could worsen already
onerous debt burdens in many of them (e.g. Italy).
Another issue is the need to anchor expectations to make sure
that temporary movements in inflation do not feed into wages and
prices and hence become permanent. This has looked increasingly
worrisome recently (see third chart). As inflation expectations
fall, real interest rates rise and given the limits to how far
nominal short-term rates can be lowered, monetary conditions could
end up tightening.
Parallels were also drawn with the post-bubble Japanese
experience: i.e. successively lower peaks in core inflation during
each expansion, followed by a series of downturns which eventually
tipped the economy into deflation. A key ECB objective, therefore,
was to build a sufficient "buffer" to avoid such an outcome.
Arguments against a Japan-like scenario occurring in the
eurozone include the continued ability of policy makers, when
working in concert, to reflate the economy, plus the historical
downward rigidity of wages and prices in Europe. But how convincing
are those arguments currently?
Regarding the former issue, the ECB has already signalled that
the door is open to additional QE and a lower deposit facility
rate. We expect both to be announced in Q3. But as we outlined in
our recent Special Report, the impact of additional monetary policy
easing will be limited. Other policy levers, including fiscal
stimulus, will need to be used much more effectively and we have
doubts about the efficacy of the policy framework in the eurozone.
Regarding the latter issue, historically there have been rigidities
in wage and price setting. But that may not apply to the same
extent post-crisis given the various supply side reforms which have
been introduced.
In our baseline scenario, we do not expect a severe shock to
push the eurozone into a downward spiral. We expect low but
relatively stable growth and inflation rates in the coming years.
However, we are cognisant of alternative scenarios, particularly
lower probability-higher impact type outcomes. The absence of an
inflation "buffer" in the eurozone so late in the cycle is a cause
for concern in that respect.
Posted 16 July 2019 by Ken Wattret, Chief European Economist, IHS Markit