Tuesday 23/07/2019

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Will the ECB reach the target of 2% inflation ever again?

Chief Economist

Last week's first-quarter growth figures for the euro area came in above expectations. Economic activity increased by 0.5% (2.1% annualized) compared to the last quarter of 2015, and 1.5% compared to the same period last year. This is in itself a solid performance. That said, economic activity in the euro area has only just passed its pre-crisis peak level. Talking about a lost decade, therefore, seems far from exaggerated.

 

Last week's first-quarter growth figures for the euro area came in above expectations. Economic activity increased by 0.5% (2.1% annualized) compared to the last quarter of 2015, and 1.5% compared to the same period last year. This is in itself a solid performance. That said, economic activity in the euro area has only just passed its pre-crisis peak level. Talking about a lost decade, therefore, seems far from exaggerated. The challenges for the monetary union and the EU by extension remain big, particularly against the background of rising populism (not an exclusively European phenomenon by the way), a sluggish agreement with neighboring Turkey regarding the refugee crisis, and growing mutual distrust between Member States. Meanwhile, little progress is being made with regards to further fiscal integration, most is probably a necessary for the survival of the currency union in a longer term perspective. In the short term, new elections in Spain, difficult negotiations between Greece and its creditors and the doomsday scenario of a Brexit could become stumbling stones. Good luck.

But what if we were to assume that the Eurozone can avoid these dangerous cliffs and economic activity could continue to surf smoothly? With today's record low interest rates, low commodity prices and low exchange rates, weather conditions look pretty well. And what could this mean for Draghi and Co’s monetary policy, which is currently under attack all too often? When would the underlying rate of inflation sustainably reach the target of around 2% again? Forecasting is difficult, but fortunately economic theories can still help us a long way. Based on the historical relationship between inflation and unemployment (the so-called Phillips curve) on the one hand, and unemployment and economic activity (the so-called law of Okun) on the other hand, we can try to estimate this. As a reminder: today the unemployment rate in the Eurozone stands at 10.2% and core inflation hovers around a meager 1%. Well, this exercise shows that the unemployment rate should fall to about 8% before core inflation would sustainably climb to the target of 2%. Assuming that that the Eurozone can maintain the current growth rate of 2% (an optimistic assumption), it would take a little over three years for the labor market to recover sufficiently in order to get the underlying inflation at the desired level. By comparison: with a growth of 1.5%, still well above the average of 0.9% since early 2010, it would take more than five years to get the job done. The latter already takes into account the fact that there was a trend change since the crisis. Due to the aging population and because part of the discouraged labor force withdrew from the labor market since 2009, less economic growth is needed to reduce unemployment to the same extent. This, of course, assumes that nothing goes wrong along the way. Again ... good luck.

The upshot is that monetary policy in the euro area, even in the most optimistic scenario, will remain very loose for quite some time. That outcome may be not be surprising in itself. On the other hand, judging from the criticism that the zero interest rate policy has received in recent years, this still seems poorly understood. A lot of critics, for example, have never fully grasped the dire situation the Eurozone is currently in. And many of them have never presented a clear and coherent alternative or model either. A coordinated expansionary fiscal policy could be a response but many observers see this as being irresponsible towards future generations, even though financial markets today are willing to lend of free of charge. This, however, does not mean that the current monetary policy is a panacea, nor is it risk-free when it comes to financial stability. It can't be excluded  that the introduction of negative interest rates and quantitative easing measures could jeopardize the above mentioned economic theories and that inflation would rebound faster. The latter result would be highly desirable, but also far from guaranteed. Just look at Japan, where the combination of a robust stimulus policy and very low unemployment rate still does not create the desired inflationary pressures. Anyway... good luck.

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