The return of inflation

By: Eurointelligence ECB Watch

In the UK, the consumer price index will this week probably show another out-of-bounds increase of over 3%. In the US, the latest data for core inflation are 2.5%, and headline inflation of 2.8%. In both cases, the underlying price pressures are in fact significantly higher. The problem is, as Charles Bean, chief economist of the Bank of England, and Frederic Mishkin, a governor of the Federal Reserve Board, have both said it recently: it is difficult and costly to lower inflationary expectations from present levels – as the link of economic growth and inflation is no longer as strong as it used to be. In both cases it would take a prolonged period of high interest rates to reduce inflationary expectations down to 2%. In the US, this is unlikely to happen, given that the Fed operates under a dual mandate, which also includes stabilisation of employment. In the UK, a shift is more probable – given the Bank of England sole focus on meeting its inflation target of 2% - with a band ranging from 1%-3%. While UK inflation will fall back to about 2% this year for reasons largely connected with the base effect, price pressures are bound to grow in the medium-term.

What about the euro area? The euro area, too, is not exempt from global phenomena. While China and the rest of Asia have exported deflation in the early part of the decade, they are now exporting inflation. Furthermore, global liquidity is ample, and much of it is flooding into the euro area. The strong economic boom is already leading to some capacity constraints. So if you desperately want to panic, there are enough reasons that allow you to do so.

However, there are some indications why the euro area is in a better position to keep inflation stable. The first is monetary policy. The ECB has reacted to the increase in money supply and credit far earlier than other central banks. Jean-Claude Trichet has made the point that without the monetary pillar, the ECB would have started to raise interest rates much later than in late 2005. Furthermore, the ECB is more likely to err on the side of caution in its future interest rate policy.

The second reason is the exchange rate, which matters more for the euro area than for the US in terms of its impact on inflation. The euro's rise both against the dollar – and the RMB by extension – and the yen provides some insurance. We believe that the ECB will either raise rates to 4% and above, or, more will probably, the exchange rate will do the job. In any case, we should expect a further tigthening of monetary conditions – at a time when inflation is not yet a problem.

Third, wage settlements are surprisingly moderate. In previous cycles, this would have been the time when trade unions such as IG Metall would have been able to press home wage increases of about 8%. This year they got 4% - which is a fair amount given current inflation and productivity trends. There is a little more pressure in other euro area economies, but overall, wages are growing in line with productivity. There is at present no indication of any cost-push inflation.

Forth, the slowdown in US growth comes at a good time for the euro area. The domestic expansion is at full speed and currently spilling over into domestic consumption. If the US economy continues to race ahead at growth rates of 4%, the euro area may well have been in danger of overheating. This is not the case as far as we can tell from the economic indicators.

We would consider the euro area the one part of the world economy, where price stability is more assured than elsewhere. There are signs of significant inflationary pressures in the dollar bloc, and in the UK. Japan is on the brink of deflation, while the euro area's current inflation performance – at 1.8% - is right on target. While that number may go up, inflationary expectations, however, remain stable.

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