Macroeconomics
EAInflation:MoreAboutCredibilitythanPersistence
5 mins
As rising inflation expands globally, it is natural to draw comparisons between conditions in major economies, namely the U.S. and the euro area. Although inflation prints in both economies stand at multi-year highs, we believe the surge in European consumer prices will be even more transitory. This post considers some of the structural factors poised to maintain the region’s disinflationary trend as well as the tools that the European Central Bank (ECB) may use to bolster inflation expectations and preserve its credibility as an institution capable of influencing price stability going forward.
The euro area’s early-year, record jump in core inflation, which stood at 0.9% in May, and the continued rebound in headline inflation to 2.0% (Figure 1) signaled a firm recovery from the region’s 2020 lows. Although much of the recent increase reflects one-off effects associated with the pandemic, such as delayed sales, price imputations due to the lack of realized sales data, and the reversal of value-added tax declines in major economies, inflation is expected to continue rising to just under 3% through late 2021.
FIGURE 1
The Sharp Recovery in European Inflation and Inflation Expectations
Bloomberg as of June 2021.
Given the recent jump in prices and the lingering effects from the pandemic, what can we say about the longer-term prospects for European inflation at this point? We see three prevailing factors that will likely pressure inflation lower by next year and place a renewed emphasis on the ECB to show that it can effectively address one of the European economy’s more chronic conditions.
I. Demand Dynamics
The limited increase in European household savings during the pandemic (which was already relatively high (Figure 2)), indicates that sustained price pressure driven by pent-up demand will likely remain modest.
Unlike the breadth of the U.S. fiscal stimulus, which included direct payments to households and fueled the jump in disposable income, Europe’s more targeted approach to supporting households focused on replacing a portion of their lost income through furlough and short-time work schemes, which maintained the gradual rise in income levels. Hence, the rise in European savings is due to declining consumption and is less likely to drive a sharp pickup in demand.
FIGURE 2
Household Savings: Driven by Incomes in the U.S., Reduced Consumption in the Euro Area
Haver Analytics as of April 2021 in the U.S. and December 2020 in the Euro Area.
Furthermore, the delay in mass vaccinations as well as a more cautious approach to reopening is set to affect the summer tourism season in southern economies, such as Spain, and is another factor expected to dampen consumer demand in Europe.
II. Labor Market Conditions
The slack in the European labor market—i.e., adequate supply to meet slowly improving demand—continues to keep wage growth modest, which in turn should help keep a lid on firm’s costs and prices. For example, following a sharp decline during the acute phase of the pandemic, European labor market participation has largely recovered (Figure 3). Although the number of employees on job retention schemes across the region has remained high at over 5%, recoveries in other major economies have shown how quickly these employees can return to work.1 Meanwhile, job vacancies have started to recover, but the pace has remained relatively modest. Overall, European labor demand continues to lag that in the U.S. amid the latter’s stronger V-shaped economic recovery.
FIGURE 3
Labor Market Participation Recovering Faster in the EA
Haver Analytics as of April 2021.
*Only U.S. data available.
III. ECB Framework
While the ECB has yet to conclude its monetary policy framework review, the resulting inflation targeting framework will likely be less radical than the Fed’s recent adoption of flexible average inflation targeting. In contrast to the Fed’s stated aim to target inflation moderately above 2% for an extended period in order to achieve a 2% average over time, we expect the ECB to update its framework in line with established best practice—i.e., an emphasis on a flexible 2% inflation target in order to meet its mandate of symmetric responses to inflation overshoots and undershoots.
Bound by its mandate of price stability, which is embedded within the Treaty on the Functioning of the European Union, the ECB is often regarded as the most independent central bank in the world. Hence, a modest shift in the ECB’s objective is unlikely to usher in a prolonged period of above-target inflation.
Next Steps and the Messaging Challenge
In order to revive Europe’s inflation trajectory and restore the ECB’s credibility after years of a disinflationary threat to the economy—evidenced by medium-term inflation expectations that are consistently below target (again, Figure 1)—ECB policy will need to remain exceptionally accommodative or risk a further de-anchoring of inflation to the downside.
Yet, the Pandemic Emergency Purchase Programme (PEPP) is due to end as early as March 2022, making asset purchases beyond the PEPP program a crucial piece of the long-run policy. After all, the Governing Council has acknowledged that “headline inflation is expected to remain below our aim over the projection horizon,” so additional policy easing is needed well beyond March of next year.2 Therefore, our base-case scenario calls for a doubling of the existing $20 billion per month in asset purchases under the Asset Purchase Programme (APP).
Messaging challenges lie ahead, however. For example, the policy messaging of a “dovish PEPP tapering” on the back of an improved outlook for growth and market functioning could run counter to signaling an easier policy—relative to what existed prior to the pandemic—beyond March 2022. Hence, a combination of measures could effectively convey the ECB’s policy objectives. In addition to increased asset purchases under the APP, other steps that could emanate from the policy review include: more flexibility in the parameters of the asset purchase programme to provide greater discretion for counteracting adverse shocks and inflation-linked forward guidance.
While it’s tempting to draw similarities between inflation in major economies—as well as the potential reaction function of the respective central banks—it’s unlikely that persistent inflation will be a foremost challenge for the ECB. Rather, the current uptick in European inflation is bound to be short-lived amid some ingrained structural factors, and, as the region’s disinflationary trend reasserts itself, the ECB will need to take steps that include a range of effective measures that might burnish its credibility as an institution capable of maintaining price stability.
1 ECB Economic Bulletin, https://www.ecb.europa.eu/pub/economic-bulletin/html/eb202103.en.html.
2 Press conference introductory statement, https://www.ecb.europa.eu/press/pressconf/2021/html/ecb.is210610~115f4c…