Draghi's Riddle of Missing Inflation Argues for ECB Patience
(Bloomberg) -- When Mario Draghi is asked on Monday why the European Central Bank can’t yet signal tightening for the region’s resurgent economy, he can respond with a question of his own: Where’s the inflation?
At his quarterly grilling before the European Parliament -- and his final scheduled appearance before next week’s monetary-policy decision -- the ECB president is likely to be pressed about his plans for stimulus withdrawal. While euro-area data this week may show the strongest economic confidence in a decade and the lowest unemployment since 2009, Draghi can still point to consumer prices that are struggling to lift off.
The disconnect between accelerating growth and sluggish inflation is a puzzle haunting officials as they prepare to meet on June 8 in Tallinn. Draghi, who has tried to quash speculation that the ECB might opt for a faster exit from bond purchases and sub-zero rates, faces the challenge of acknowledging the economy’s gains without priming markets for action that many would consider premature.
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“Draghi will explain that the improvement in the economy is not sufficient at this point to make sure that the improvement in the inflation outlook is self-sustained,” said Philippe Gudin, chief European economist at Barclays Plc. “We are still far from the point at which we could see inflationary pressures materializing.”
Draghi’s hearing at the European Parliament’s Economic and Monetary Affairs Committee is an opportune moment to tout the euro area’s recovery -- and the role of the ECB’s 2.3 trillion-euro ($2.6 trillion) bond-buying program.
“I think he has to be quite dovish,” Peter Rosenstreich, head of market strategy at Swissquote, said on Bloomberg Television on Monday. “There’s growing expectation that inflation is building and that the time for unorthodox extreme monetary policy is now coming to an end.”
Economic activity, as measured by a Purchasing Managers’ Index, is at the highest in six years and at levels that in the past have warranted monetary tightening. Data on Tuesday is is likely to show economic confidence at the strongest in almost a decade, and figures the next day will probably reveal an unemployment rate at the lowest since early 2009. In Germany, the euro area’s economic powerhouse, business sentiment is at levels not seen since at least 1991.
But Draghi’s four-year inflationary campaign has so far failed to put price growth on a self-sustaining path toward the ECB’s goal of just under 2 percent. If anything, there are hints that the target is receding further into the future. Economists predict that data due Wednesday will show the inflation rate fell to 1.5 percent in May from 1.9 percent. More worryingly for the central bank, core inflation is slated to slow to 1 percent.
Underlying the difficulties faced by the central bank, money-supply growth slowed to 4.9 percent in April from 5.3 percent.
Even if those are temporary blips, the longer-term outlook shows that price pressures will increase only gradually. According to Bloomberg Intelligence research, inflation will accelerate to 1.8 percent in 2021, two years after the end of Draghi’s term. The European Commission cut its forecast for 2018 inflation to 1.3 percent and the ECB, which is updating its own forecasts to be published at the June policy meeting, may have to follow suit.
With numbers like these, Draghi and his closest collaborators last week restated that the ECB will stick to its current normalization plan, which foresees rate increases only well after asset purchases have been tapered. The quantitative-easing program is currently scheduled to run at 60 billion euros a month until at least the end of the year.
While the exit debate within the Governing Council will probably start in earnest at the Tallinn meeting, it may yield only minor changes to policy communication for now, such as the removal of an explicit pledge to cut rates further if needed or the recognition that risks to the recovery are no longer skewed to the downside. Even that may be too much for some.
“The recovery in the euro area is resilient and increasingly broad-based even if overall risks remain tilted to the downside,” Vice President Vitor Constancio said on Thursday. The continuation of “monetary stimulus remains important to ensure a sustainable adjustment of the inflation process.”
A missing element in the ECB’s inflation mix is wages, which have been rising very slowly despite falling unemployment, even in countries like Germany where joblessness is at a record low.
“We have discussed quite extensively why wage increases are relatively subdued, but in my view this is a matter of some time lag,” Governing Council member Ewald Nowotny said on Monday. “If the upswing gets more consolidated, we can expect higher wage dynamics, which means that also core inflation might get stronger.”
As many of the jobs created since the crisis are short-term or part-time, the labor market may have greater spare capacity than official measures suggest, leading workers to opt for more hours before higher salaries. A pick-up in real wages may have to wait until the beginning of next year, when many collective contracts will come up for re-negotiation.
That’s all reason for Draghi to stick to his rhetoric of patience and caution.
“He’s not yet sufficiently confident on the durability of the inflation recovery, and there are few signs of an improving core-inflation outlook,” said Anatoli Annenkov, senior economist at Societe Generale in London. “I doubt his message will change much compared to recent appearances.”