Macroeconomics
WhytheECBCanLookThroughHigher-than-ExpectedInflation
5 mins
At 5.0% for the 12 months through December 2021, euro area HICP inflation continues to come in higher than expected. The most recent data release confirms a growing trend of inflation “surprises” in the past year (Figure 1). Some investors believe that the European Central Bank (ECB) is behind the curve and needs to tighten policy. However, our analysis shows that the ECB has ample reason to tread carefully.
Figure 1
Growing Divergence Between Euro Area Inflation And ECB Forecasts
European Central Bank as of January 2022.
Inflation in the euro area is running at a rate not seen since the early 1990s, and the ECB expects it to remain high until at least the middle of this year (Figure 2). Indeed, if energy prices continue to rise — which is entirely possible given the fragile relationship between Russia and the West and limited reserves in Europe — inflation could rise even more than expected. For example: a further €25/megawatt hour rise in wholesale gas prices and a further €10 per barrel rise in oil prices could add around 0.5 percentage points (pp) to inflation within a quarter. So, do the critics have a case and should the ECB tighten policy?
Figure 2
Euro Area Inflation Projections
PGIM, Haver Analytics, as of January 2022.
Many investors overlook the point that most of the euro area’s inflation surprise isn’t the result of unexpectedly stronger economic activity. Instead, it is caused by an unanticipated rise in energy costs and by unexpectedly higher prices for products that experienced global supply chain disruptions due to the pandemic, such as cars and household electronics.1
In Figure 3a, we estimate a lower and an upper bound of this effect. Our conclusion is that energy and supply chain disruptions account for most, if not all, of the past year’s inflation surprise.
Figure 3A
Estimated Contributions To The Surprise In HICP Inflation Since the ECB’s December 2020 Projections
Eurostat, PGIM Fixed Income, as of January 2022.
Figure 3B
Services’ Contribution To Euro Area HICP Inflation Has Fallen Since 2019
Eurostat, as of January 2022. Note: Estimates of the impact of energy and supply chain issues in Fig 3a are top-down calculations based on energy price futures, changes in published ECB forecasts,2 the contribution of energy sub-indices to headline inflation, estimates of the level of dynamics of indirect energy prices on headline inflation.3 These estimates are robust bottom-up calculations based on more granular HICP sub-indices that are sensitive to energy prices and supply chain issues.
By contrast, other economic data paint a benign picture of underlying inflation. Euro area gross domestic product (GDP), for example, has only just recovered to its pre-pandemic level. In contrast to the United States (click here for our view on the Fed in 2022), euro area negotiated wage growth is at a multi-decade low. The average contribution of services inflation, an indicator of domestically-generated inflation, was lower in 2021 than in the three years before the pandemic (Figure 3b).4 Finally, a broad range of survey- and market-based measures of inflation expectations remain below the ECB’s inflation target.
The bottom line is that, once unexpectedly higher energy prices and supply chain disruptions are accounted for, there is no indication that underlying inflation is drifting meaningfully above the ECB’s 2% target.
So, what is the policy prescription for the ECB? Fundamentally, the pandemic’s multiple waves have caused severe supply shocks, which can pose a well-known dilemma for monetary policymakers: such large and recurring negative supply shocks can trigger protracted rises in headline inflation and push down output, but leave underlying, domestically-generated inflation relatively unaffected.
Such a scenario played out in the UK economy after the global financial crisis of 2008: CPI inflation rose to 3.5% in January 2010 and accelerated to 5.2% in September 2011. It only returned to the Bank of England’s target in late 2013 and did so without monetary tightening. The data suggest that a similar dynamic may be playing out in the euro area now.5
Despite high recent inflation, the ECB has good reasons to stick to its remit and set policy to meet its medium-term inflation target of 2%. As long as the negative supply shocks associated with the pandemic do not lead to second-round increases in nominal wage growth or inflation expectations that are inconsistent with the target, the ECB can look through the impact on headline inflation. Doing so is completely consistent with credible inflation targeting, which foresees that inflation may deviate from its target due to unanticipated shocks.
Not looking at the underlying picture would entail an undesirable degree of output volatility at this fragile time. Indeed, tightening policy now would have no impact on inflation in the coming months and would risk permanent economic scarring from the pandemic, as in the global financial crisis and the region’s sovereign debt crisis. Moreover, premature tightening would push the medium-term outlook for inflation even further below the ECB’s target, threatening a possible de-anchoring of inflation to the downside.
Higher inflation is undeniably acting as a squeeze on real incomes that is painful for households and will weigh on the recovery. But the ECB cannot magic the pandemic away. Similarly, the central bank cannot affect geopolitics, the global chip shortage or the fact that Europe may need to pay a higher price for energy as it transitions towards renewable energy. The fact is that these fundamental changes require a shift in relative prices, which no setting of monetary policy can prevent.
The alternative, embedded in the ECB’s inflation targeting regime, is for monetary policy to continue to ease this recovery. It can do so by setting policy in a predictable and transparent way that is consistent with achieving its medium-term inflation objective of 2%. Our analysis of what underlies these current surprises in inflation shows that the ECB has ample grounds to tread carefully.
1See Hackworth, Radia and Roberts (2013), Understanding the MPC’s forecast performance since mid-2010, Bank of England Quarterly Bulletin, Q4 for a similar analysis. Our analysis is based on a number of assumptions detailed in Fig 3a, as we do not know the ECB’s conditioning assumptions for individual components of HICP.
2https://www.ecb.europa.eu/pub/projections/html/ecb.projections202012_eu…
https://www.ecb.europa.eu/pub/projections/html/ecb.projections202112_eu…
3https://www.bancaditalia.it/pubblicazioni/qef/2017-0405/QEF_405.pdf
https://blocnotesdeleco.banque-france.fr/en/blog-entry/impact-oil-price…
4Services inflation is not immune to higher energy prices, though the impact is found to occur with a lag of up to four quarters for airfares. See Kalanta and Ouvrard (2018), The impact of oil prices on inflation in France and the euro area, Banque de France https://blocnotesdeleco.banque-france.fr/en/blog-entry/impact-oil-price….
5A similar case was made for the UK following the global financial crisis. See a speech given by Mervyn King (2011), https://www.bankofengland.co.uk/-/media/boe/files/speech/2011/speech-by….