The economic recovery and the inflation puzzle
According to Eurostat estimates, annual inflation in the Eurozone in June was 1.9% compared to the 2% estimated in May. Core inflation (which excludes goods with volatile prices, such as food and energy) recorded 0.3% while harmonized inflation (which allows the overall trend of the Eurozone to be determined) confirmed 0.9% of the previous month. The ECB’s objective is an increase in inflation at a rate of less than but close to 2% over twelve months in the medium term. With the progress of vaccinations and the launch of the Next Generation Eu, European economies are ready to restart. At this moment the financial markets are looking with interest at the future choices of the ECB, called to decide between maintaining the expansionary orientation or a monetary tightening to prevent inflation from getting out of control.
Lagarde falcon or dove?
Even before the arrival of the pandemic, the ECB failed to hit the inflationary target, despite the quantitative easing launched by Mario Draghi and maintained, albeit reduced, by Christine Lagarde. Following the devastating impact of the health crisis on the economy, despite some initial hesitations, the ECB launched the precious 1,850 billion euro Pandemic Emergency Purchase Program (PEPP).
Speaking on June 21 at the Parliament’s Economic and Monetary Affairs Committee, Lagarde said that inflation has increased in recent months in the euro area, largely due to temporary factors, including strong increases in energy prices. Headline inflation is expected to pick up further towards the autumn, continuing to reflect temporary factors and monetary tightening would be premature. Therefore, at least for the next few months, the ECB’s orientation will remain expansive, to bring inflation stably to the target level and avoid an early intervention that would undermine the recovery of the economy.
In this phase it is necessary to look at inflation with caution, monitoring the trend of the more volatile prices of those goods whose demand currently exceeds supply, in a phase of restarting production and a physiological increase in consumer demand. Furthermore, it is easier for monetary policy to curb inflation than to stimulate it, especially if nominal interest rates are close to zero or negative. If the engine of the European economy were not yet able to proceed autonomously, a restrictive monetary policy could have negative repercussions on GDP and push away the inflation target close to 2%.
Furthermore, the anticipated increase in interest rates would lead to an increase in the cost of debt for households, businesses and governments. In the worst case the Eurozone would go towards deflation. At that point, the ECB would not have many other strings to its bow, excluding the less credible solutions of helicopter money or the monetization of public debts.
What is the Fed doing?
In the United States, the scenario is very different. In May, the annual inflation rate was 5% (core inflation 3.8%). The Biden administration’s public investment plan, the Federal Reserve’s accomodative policy, the rise in commodity prices and the rising wage demands in the post-pandemic labor market are some of the main factors that are leading to such a high level of inflation. Financial markets fear an upward price-wage spiral and an erosion of the real yield of US government bonds. Joe Biden has recently reached a bipartisan agreement on a $1.2 trillion infrastructure plan, while the US economy has restarted, or rather, it has never really stopped. In May 2021, the unemployment rate was 5.5%, compared to 13% in May 2020 and in the first quarter of this year, GDP grew by 6.4%. For the time being, the Fed is maintaining an expansionary orientation through quantitative easing. Unlike the ECB, the Fed does not consider the option of negative rates, which are considered harmful to the proper functioning of the market. Since August 2020, the US central bank has adopted average inflation targeting, or an inflation rate of 2% on average over time, after abandoning the target of 2% in twelve months. The Fed intends to direct monetary policy towards achieving full employment. Under the new rule, the central bank can keep interest rates low even if inflation exceeds 2%. However, markets see the overheating of prices as a symptom of the economic recovery and are waiting for monetary tightening. But at the moment, it does not seem to be on the agenda of the Fed Board of Governors, which considers the inflationary phenomenon to be transitory.
The expectation control
Central banks play for credibility and reputation on inflation control. In addition, the ECB has the burden of being “the only player on the field”, waiting for a federal fiscal policy. Through open market operations, policy rates and monetary base, central banks must achieve price stability and intervene with expansionary or restrictive measures depending on the phase of the economic cycle. As already mentioned earlier, it is easier to brake inflation than to stimulate it, but it is also necessary to take into account expectations about future prices. According to the monetarist theory, expectations about future prices affect price setting and wage demands. An increase in expected inflation leads to an increase in the expected opportunity cost of holding money. This implies a decrease in the demand for money and the excess liquidity induces individuals to increase the demand for consumption and investment. In the presence of full employment, the increase in demand leads to an increase in inflation. All this starts from the optimistic expectations about expected inflation. This is why it is essential that a central bank carefully weighs the size, timing and communication strategies of monetary interventions.
Keynes and the monetarists
Unlike the monetarist scheme, the Eurozone is not currently in full employment. The labour market is in a state of imbalance. According to Keynes, in the presence of unemployment, it is necessary to devalue real wages through an increase in the money supply. The reduction in real wages pushes businesses to increase the demand for labour, until the point where it exceeds supply, eventually generating an increase in nominal and real wages such as to bring the economic system back to the level of output at full employment. On the other hand, according to the monetarists, money is neutral, as every decision to increase inflation in the system is absorbed by the expectations of operators on the basis of which they adjust prices and wages. As a result, the only way to make monetary expansion effective is an inflationary spiral. This would undermine the credibility of the central bank. An expansionary monetary maneuver, if too strong or not timely, could lead to an increase in inflationary expectations in individuals, and this could lead to an increase in long-term interest rates, rather than a decrease.
This is the main risk that central banks will face in the coming months. In case of an early increase in interest rates, the risk is that of sacrificing output growth in order to contain inflation. The immediate consequences would be on public finances (Italy would be more exposed than other countries) and, in particular, on state bonds to be renewed at the new interest rates.
The Fed’s mandate sets the dual objective of full employment and price stability. With the adoption of the new rule, the central bank has decided to give priority to the first objective. The ECB’s mandate, on the other hand, is based exclusively on price stability and constitutes a guarantee of credibility for the central bank. But soon Lagarde will face a decisive choice for the future of the Eurozone. How far will she be willing to push on the inflation accelerator in order to actively support the growth of the area’s output? Between hawks and doves, the game is open.
