Global Daily – Why the ECB’s inflation strategy has stalled

by: Nick Kounis

ECB View: The growth slowdown is the latest blow to generating inflation – The ECB’s key monetary policy objective is ‘to maintain inflation rates below, but close to, 2% over the medium term’. It has not managed to achieve that over the last few years in a sustainable fashion. From 2014 onwards, the ECB embarked on an aggressive monetary easing campaign to put this right. The strategy in a nutshell was to engineer a long period of above-trend economic growth, which would substantially push down unemployment, leading to tighter labour markets, higher wage growth and eventually a rise in core inflation.

This strategy has now stalled. Economic growth has slowed to below-trend rates. Indeed, in the second half of last year, the economy expanded at rates around half the trend rate. While we expect the economy to regain some traction during the course of this year, we do not expect a return to the strong rates of expansion necessary to keep unemployment on a downward trend. At the same time, the unemployment rate is flattening out at levels consistent with ongoing slack for the eurozone economy as a whole. The unemployment rate – at 7.9% – is still comfortably above its pre-crisis lows (7.2%). In addition, the broader U6 unemployment rate measure is significantly above those levels (16.6% versus 14.9%). The US experience suggests that wage growth did not strongly accelerate until unemployment fell back to those historically low levels. The negotiation position of workers in advanced economies has weakened over the years due to globalisation and the decline in trade union membership. In the eurozone,  the rise in the share of low quality temporary jobs and labour market reforms exacerbate these trends.

To make matters worse, the link between wage growth and inflation might be weak in the current macro environment, increasing the challenges for the ECB’s strategy. A research note published by ECB staff economists today (see here) finds a ‘strong link between labour cost and price inflation’, however also that the pass-through of wages to inflation is ‘systematically lower in periods of low inflation as compared to periods of high inflation’. This might be related to expected low inflation persistence. Indeed, we note that market inflation expectations as tracked by the 5y5y inflation swap, have fallen over the last few months and appear to be anchored at significantly lower levels than the trends seen pre-crisis.  Low inflation expectations are also a factor that are likely dampening pay settlements.

In addition, it is likely that the pass-through of wage growth is lower in a weaker growth environment as companies may lack pricing power. Bank of Italy Governor Ignazio Visco seemed to allude to this at a the annual Assiom Forex conference in Rome on Saturday. He noted that ‘the transmission of the increase in wages to prices has been slowed by the weakness of economic activity in recent months’.

What does all this mean for the outlook for inflation and consequently ECB policy? Our view is that underlying inflationary pressures will remain subdued, with core inflation likely to significantly undershoot the ECB’s current projections. To get the inflation strategy back on track, the ECB needs to maintain its highly accommodative monetary policy stance for longer. It may possibly need to add stimulus to get the economy running hot again depending on global economic developments. We expect the ECB to keep interest rates on hold until 2020. However, we see the risks skewed towards an even longer period of unchanged interest rates given the slow growth environment and subdued underlying inflationary pressures. Furthermore, we expect the ECB will announce an extension of its TLTRO programme. (Nick Kounis)