ECB Hits Fifth Anniversary of QE Puzzled by Inflation Gap

Lagarde’s New ECB Starts With Old Question of Missing Inflation

Piotr Skolimowski

23 Jan 2020, 11:43 AM IST

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Five years to the day since the European Central Bank announced massive cash injections to stave off deflation, President Christine Lagarde wants to know why price growth is still so lackluster.

Economist Milton Friedman’s decades-old dictum that inflation is “always and everywhere a monetary phenomenon” -- implying that prices will rise if you create enough money -- is under strain. The ECB has failed to sustainably hit its goal, much of the rest of Europe has similarly struggled, and Japanese prices have been in the doldrums for a generation.

ECB Hits Fifth Anniversary of QE Puzzled by Inflation Gap

While the U.S. Federal Reserve has fared a little better, with fiscal help, policy makers there are scratching their heads in a strategic review. Now Lagarde intends to agree on the ECB’s own wideranging review at a two-day policy meeting starting Wednesday. It’s the Governing Council’s 500th gathering and comes half a decade after former President Mario Draghi announced quantitative easing as the ultimate tool for restoring price stability.

Policy makers want a convincing explanation for why it hasn’t turned out that way, and how they can respond. At least they don’t have to start from scratch. Researchers have offered multiple explanations including globalization, digitalization and the demise of trade unions.

Weaker Workers

Perhaps the biggest quandary is why tight labor markets haven’t generated wage increases big enough to push up consumer prices. The U.S. and U.K. have the lowest unemployment in decades.

One argument in the euro zone, where joblessness is the lowest since 2008, is that the European Union’s eastern expansion led to an influx of cheaper workers. The threat that companies might move factories also restrained pay, especially in Germany, according to a 2017 paper by Christian Odendahl of the Center for European Reform.

The decline in organized wage bargaining may also have a role. The share of French workers that are members of a trade union is down to 9% from 23% in 1975. In Germany, it fell to 17% from 35%. That trend has affected “real disposable incomes, consumption growth and, ultimately, inflation,” ECB Executive Board member Benoit Coeure said in his final speech before his term ended last month.

What Our Economists Say...
“Those looking for the causes of low inflation in the euro area would do well to start with Germany. There, slow price gains are nothing new -- core inflation has averaged just 1.1% since 2000. In part, that reflects an agreement between employers and workers that secured jobs in exchange for pay restraint. It’s hard to see inflation picking up sustainably until that dynamic sees radical change.”
--Jamie Rush. Read more.

Flat Expectations

Even in nations where wages are picking up, the effect on inflation has been muted, casting doubt over the relationship between prices and economic slack known as the Phillips curve. ECB research has sought to prove the curve still holds, even if it’s flatter than it used to be. Perhaps key is a study in July showing inflation expectations to be the most important determinant of underlying price growth.

AXA economist Gilles Moec says the implication is that “core inflation today is influenced by past episodes of very low or very high headline inflation.” For price growth to really kick in, the ECB needs plenty of patience and the willingness to let inflation to run above its target.

Still, a Bundesbank paper last month suggested it’s not so simple -- perceptions about living costs also differ depending on factors such as earnings, education and job type.

Connected World

Globalization is frequently blamed for depressing wages and inflation, as companies move production and services to cheaper locations, such as laptop assembly in China or call centers in India. Former Bank of England policy maker Kristin Forbes concluded in a paper last year that economic models need to do a better job of including global factors.

Technology, such as ride-sharing app Uber, may also be a factor, aiding the rise of the gig economy with its low job security. The “Amazon effect” has intensified retail competition, forcing companies to compete globally while central banks operate within their currency area.

ECB board member Yves Mersch has described how technology makes it difficult to get an accurate reading on inflation, as companies like Google offer services for free while extracting profits from advertising.

Export Problem

A working paper by the Irish central bank last year found a correlation between the euro area’s current-account surpluses after 2011 and low inflation, a link acknowledged by ECB chief economist Philip Lane.

That may signal European manufacturers are too reliant on foreign demand. While the services sector is growing faster than manufacturing, even that trend brings another problem. Coeure said services prices are considerably “stickier” because they have a high wage component, increasing the lag between monetary policy and price changes.

Home Truths

Finally, it’s possible inflation hasn’t gone missing but is simply being overlooked. The gauge used by the ECB -- produced by the EU’s statistics office -- only gives housing costs a weight of 6.5%, well below what most people pay. About a third of the basket of goods and services tracked by the Federal Reserve is housing.

Still, Greg Fuzesi, an economist at JPMorgan, has done research showing the impact on inflation from adding housing costs is overestimated.

The complexity of factors affecting inflation, and the fact that some of them are outside the reach of central banks, makes finding a solution tricky. One governor, Austria’s Robert Holzmann, reckons the best strategy is acceptance -- lowflation might be here to stay.