Eurozone inflation? It’s all in the mind

Date: 03/11/05

When asked what would drive his government's foreign policy, a former UK prime minister replied: "Events, dear boy, events." Today, if the industrial world's top central bankers were asked what would drive monetary policy, many would reply: "Expectations, cher ami, expectations."

At a seminar at the Bank of England last month marking the 20th anniversary of the founding of the journal Economic Policy, a participant said: "The &036;64,000 question central bankers are asking today is: 'How fragile is the current anchoring of inflation expectations, how big an [oil] shock can you throw at the system and have it survive?'"

After the doubling of oil prices in the past two years, workers and firms could look at the rise in the prices of goods and services they buy and say the time has come to ask for higher wages, or higher prices for what they sell, to compensate for the loss of purchasing power they have suffered so far and the expected losses that lie ahead.

So, are we on the brink of a new wage price spiral, with the emergence of so-called second round effects, which will undermine belief in the low inflation environment which the European Central Bank (ECB) has sought to establish and with it the anti-inflation credibility of the ECB itself?

This worry and the effects on credit growth of the historically low short-term interest rates the ECB has stuck to for over two years help to explain why, in the past few weeks, the ominous drumbeat of EU central bankers softening up the markets for an interest rate increase has been echoing. There were even fears that when the ECB meets on Thursday (3 November) it might follow the example of the US Federal Reserve which on Tuesday raised rates for the 12th time in two years to 4%.

Eurozone inflation has been remarkably stable in the face of the oil shock, certainly when compared with the 1970s. Eurozone inflation peaked at 3.1% in January 2001 and has since been consistently above, but very close to, the 2% figure, which is the ECB's yardstick for price stability. Through the summer there was a bit of a jump to a peak of 2.6% in September, before Eurostat's harmonised consumer price index eased back to 2.5% last month, a bit more than half the current US rate.

On this evidence and with only a fragile economic recovery showing through, many would say that the ECB should not even be thinking of raising rates, especially since, if you strip out a few exceptional items such as oil prices, so-called core inflation is even lower at 1.5%.

But it is the actual cost of living, how much you have to pay now to fill your petrol tank, not some economist's estimate of what may or may not be the 'underlying' rate of inflation, which helps to create the inflation expectations that can lead to a wage-price spiral. Similarly, expected inflation drives the price of bonds and therefore of the medium and long-term interest rates which influence corporate investment decisions. If expectations of future inflation start rising, longer-term interest rates will increase and financing conditions for firms deteriorate.

Echoing the evidence of the ECB's own surveys and other indicators of expected inflation, Spain's central bank governor Jaime Caruna has insisted that "there is still no clear evidence of ...second round effects". The word "clear" is interesting.

As one top EU economic policymaker remarked last week, reacting when the evidence of second round effects has appeared may already be too late. The seeds that turn into the roots of a new inflationary psychology, may already, by then, have been sown. By not acting pre-emptively, says another EU economic policymaker, the central bank may even be helping to fertilise them.

Michael Dicks, an economist at investment bankers Lehman Brothers in London, was not expecting an interest rate rise from the ECB this week. "Given sluggish growth and forecasts for low inflation next year we think an ECB rate increase would be a mistake," he said.

But the financial markets are putting at 50% the chance of a rate increase in December, he added.

So there is likely to be a spirited debate about economic policy and the role of inflationary expectations at next week's Eurogroup and Ecofin meetings (7-8 November).

Stewart Fleming is a freelance journalist based in Brussels.

Analy7sis feature in which the author takes a look at so called second round effects springing from inflation expectations.