Article 127 of the European treaty states that the ECB’s main mission is to maintain price stability; as President Mario Draghi has repeatedly said, this means targeting the “sustained convergence of inflation to levels that are below, but close to, 2% over the medium term”. But the ECB’s inflation forecasts for 2021 are just 1.6%. Is the ECB throwing in the towel on low inflation?
- Central bankers are no longer afraid of inflation…
- …and are even trying to push it up
- Inflation-linked bonds are likely to benefit from this new approach
Inflation is low…
In early 2019, Eurostat tweaked its 2018 inflation rates, but did not change the inflation trends. Year-on-year inflation was 1.4% in January and 1.5% in February, down from 2.3% in October. The early-2019 retracement was due mainly to falling energy costs, in line with lower crude oil prices. Core inflation (i.e. ex food and energy) stood at just 1.0% at the start of 2019. It has in fact been stable at around this level for the past few months.
Headline inflation was below 2% in 13 of the 19 eurozone countries. The chart below illustrates one of the ECB’s well-recognised dilemmas – it must implement a single monetary policy and meet a single inflation target in countries that are facing different economic challenges and in which specific economic policies have been put in place by their respective governments. To take one example, the acceleration in headline inflation in the Netherlands reflects an increase in the lowest VAT rate (from 6% to 9%) and taxes on energy products put through on 1 January 2019.
… and is likely to stay low
This conclusion emerged clearly from the 7 March meeting of the ECB’s policy-setting governing council, announcing new economic support measures (detailed in this document). In reaction to the European economy’s uncertainties and given the downside risks, president Draghi chose to put a more dovish face on the ECB’s monetary policy. Weaker-than-expected growth appears to be postponing the day when inflation will converge towards the ECB’s target.
Chart 2: ECB staff macroeconomic projections, March 2019
In stating that key rates “will remain at their present levels at least through the end of 2019”, the ECB’s forward guidance has aligned with economists’ projections and is now closer to market expectations (which nevertheless remain far too conservative).
Aren’t central bankers afraid of inflation anymore?
Its recent decisions show that, like the US Federal Reserve, the ECB is clearly more concerned about economic growth than the risk of inflation. However, the ECB has been less direct since its mandate concerns price stability; the Fed's dual mandate is focused on maximum employment and stable prices.
Moreover, while the inflation target is based on the harmonised index of consumer prices (HICP), given that the target concerns the medium term, the ECB comments freely on shifts in the core inflation index (i.e. ex food and energy) that depend more on economic conditions in the eurozone itself and may actually be influenced by monetary policy.
Can we be so sure that inflation in the eurozone will not suddenly accelerate?
In its June 2018 Economic Bulletin, the ECB published an article on core eurozone inflation measures that placed HICP measures of price stability alongside “generally observed measures of core inflation”. Among these are “super-core” inflation figures, designed to measure underlying internal inflationary pressures. They consist solely of non-food and non-energy HICP components, which are “deemed sensitive to variations in the economic activity cycle as measured by the output gap”.
How did we get from rather a simple concept that everyone can understand in daily life (the increase in consumer prices) to indices involving econometric techniques and the estimate of output gaps – something that that has been especially difficult since the Great Recession?
This is a long story that can be summed up in two words: “enlightened pragmatism”. Estimates of the potential output gap are converging and are in the process of closing up entirely. Economic theory teaches us that pressure on production factors (including labour) results in inflationary pressures (via acceleration in wage growth).
While wage costs are only just beginning to trend upward with modest increases in real terms, consumer price indices are not reacting and core inflation is still far below the target level. This is why several price indicators that could hold the answer are being closely monitored. Familiar with economic theory, the ECB is sticking to its line that inflation will ultimately converge towards its target. It is right to do so, but it also acknowledged in March that this would probably take longer than expected and has adjusted its forward guidance accordingly.
Some market participants used to call the longest-term inflation forecasts “aggressive”. Well, the ECB’s forecast for 2021 (1.6%) is lower than the projection of ‘professionals’. This has not happened in at least five years. So, the ECB is changing its strategy – it no longer focuses on the need to anchor inflation expectations, as shown by inflation-linked bonds (i.e., the five-year, five-year forward inflation expectation rate), but it is projecting a lower level to leave room for ‘nice surprises’ regarding this threshold.
Market participants will therefore have to focus more on the increase in inflation, and less on the fact inflation is still low in absolute terms. The ECB’s announcement has slowed the uptrend in inflation break-evens, but has not stopped it entirely. If crude oil prices continue rising, even slightly, positive news for inflation will likely boost the performance of inflation-linked bonds.
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