Hurray, inflation is back?
Contrary to a number of public comments, the recent return of inflation in the Eurozone does not indicate that the ECB’s policies are working. Quantitative easing in particular remains mostly ineffective in stimulating demand in the Eurozone.
Headline inflation1 in the euro area has – for the first time in years – reached the ECB´s target of (below but close to) 2%. This has led to rising pressure on Mario Draghi to reroute his course of extreme monetary expansion to more moderate policies, especially from Germany, where savers now have to cope with the double burden of zero interest rates and increasing prices.
Does this mean QE is successful?
At first sight it looks like the large scale asset purchasing program of the ECB (QE) is finally showing some success. The program has been going on for more than two years now with only limited positive results. Despite the enormous monthly injection of first 60, then 80 billion Euros into the financial system every month, lending activity did not pick up as expected, investment remained weak and the risk of deflation persistently popped up again and again. Now, after years of ultra-expansionary monetary policies, prices finally seem to normalize. Do they really?
Let´s have a look behind the curtain to shed some light on current price developments. While headline inflation has indeed reached 2% in February 2017, core inflation is a much more interesting indicator to look at.
Core inflation excludes volatile price components such as energy and unprocessed food, thereby giving a much less distorted picture of price developments. And this indicator shows no strong sign of a recovery (yet). Core inflation has remained fairly stable and persistently below the 1%- line during the last months as can be seen in the following graph:
It´s the oil price, stupid!
If core inflation remains stable what is to blame for the sudden surge in price levels? The answer is simple: oil. After a serious decline between mid-2014 and 2016, the oil price is finally picking up again. In January 2016 the barrel Brent reached a 13-year low and even fell below the USD 30 mark. From this very low level the oil price slowly started to stabilize, steadily rising throughout 2016 and almost reaching USD 60 per barrel over the last couple of months as a result of OPEC´s long awaited decision to cut oil production. This clearly demonstrates the upward pressure that oil prices currently have on inflation.
For the euro area as an oil-importing economy, the impact of the oil price on the overall price level is twofold: on the one hand energy prices constitute an important component of the overall price development entering directly into the Harmonized Index of Consumer Prices (HICP) used by the ECB to measure inflation.
On the other hand oil is an important intermediate production input: higher oil prices imply higher production costs and lower profitability thereby potentially discouraging investment and output. For people, higher energy costs means less disposable income for other household budget items, and can thus dampen private consumption and aggregate demand. Hence, a higher oil price can have a negative effect on economic activity and growth.
In short, the recent inflationary trend is by no mean a signal of an economic recovery, but rather an heterogenous factor which will deepen the lack of consumer demand in the Eurozone.
What does this mean for future ECB policies?
The primary goal of the ECB is to sustain price stability with an inflation rate of below but close to 2%. When excluding the upward impact of the low oil price, this target has not yet been reached with core inflation still below 1%. The additional inflationary pressure from the oil price is usually not calling for strong reactions, as the Central Bank cannot affect commodity prices directly.
For inflation to rise continuously, some wage-cost-inflation will be necessary. A strong reduction in unemployment rates would result in wage-cost pressures as workers see their bargaining power rise. The most important indicator for a strong recovery can therefore be found in the unemployment rate, which is not looking overly great. Despite some recent gradual improvements, we still see high unemployment rates and in particular excessive youth unemployment rates of 40-50% in in Greece and Spain, creating a so-called lost generation, with dangerous negative long-term effects.
Therefore, regardless of the oil price, Monetary Policy should keep an accommodative path to help crisis-stricken countries and to bring core inflation back on track. Consequently the ECB should not contract policies too early, a mistake already undertaken in 2011, when the ECB hiked rates too quickly and triggered the so-called “double-dip recession”.
A lot more needs to be done – QE for People could be more effective and less risky
The European Central Bank is therefore right to dismiss calls for tapering QE too early or even raise rates, at least in the absence of a better alternative. That said, the question remains if QE is really the best way to avoid deflationary threats and bring back growth and employment in the euro area, and whether alternative options might not be more effective.
Risks and negative effects of current ECB policies are becoming more and more visible: stocks markets are overpriced, risking to increase wealth inequality, and the growth of credit remains largely subdued. What’s more, the ECB is unnecessarily fueling critics against itself by operating a questionable corporate bonds purchase programme and designing QE rules that can be seen as favoring some countries over others (Greece, for example is excluded from QE).
Therefore, a thorough assessment of potential negative effects of QE on the environment and income inequality is needed, while other potential policies such as QE for People should be considered in order to be prepared for the next crisis instead of having to resort to QE only. The recent short-term rise of inflation should certainly not be a pretext to elude this important discussion. In fact, if energy prices do indeed dampen consumption, some would argue this would be an additional reason to consider implementing a citizen’s monetary dividend paid by the ECB to offset the loss of purchasing power.
In the long run, what we need are policies that promote investment and foster innovation, helping SME´s to create jobs while reducing inequalities and pacing up environmentally-friendly solutions for the euro area. Obviously, these goals cannot be reached by the ECB alone, but monetary policies should at least contribute to their achievement.
Credit Picture: CC European Central Bank
1. Headline inflation measures the totality of price developments within an economy including commodities such as food and energy prices. It indicates the average change over time in prices paid by households for a particular basket of consumer goods and services.