Bill Mitchell-en Euro area inflation is not accelerating out of control
(http://bilbo.economicoutlook.net/blog/?p=49077)
(i) Sarrera
Last week (January 20, 2022), Eurostat released the latest inflation data – Annual inflation up to 5.0% in the euro area – which followed the release from the US Bureau of Labor Statistics data (January 12, 2022) – Consumer Price Index Summary , the latter, which shocked people, given that it recorded an annual inflation rate of 7 per cent before seasonal adjustment. The Euro area inflation rate over the same period was published as 5 per cent. It is obviously hard to see clearly through the data trends given the amount of pandemic noise that is dominating. But I stand by my 2020 assessment (updated several times since) that we are still seeing ephemeral price pressures as a result of the massive disruption the pandemic has caused to production, distribution and transport systems. In a sense, I am surprised the inflationary pressures have not be greater.
(ii) Grafikoak
The following graph shows the evolution of the All Groups harmonised price index and the so-called ‘core’ measure (which excludes volatile items such as energy, food, alcohol and tobacco) from the measure, which is designed to give a more stable view of the underlying price pressure.
The lines are annual rates of change (per cent).
The annual All Groups (headline) rate is 4.96 per cent in December 2021, after being 1.22 per cent at the start of the pandemic (January 2020).
However, the All Groups less volatile items (core) was just 2.62 per cent in December 2021, having been 1.09 per cent at the start of the pandemic.
The larger factor driving the All-Groups index is energy prices, which rose by 26 per cent over the year. For Europe, this was mainly the result of reductions in the gas supply from Russia.
Food and industrial goods are rising at around 3 per cent per annum (and some of that is the energy price impact on costs).
If we examine the rate of acceleration in the indexes (the changes in the rate) then over a two-year period (since the pandemic began), the All groups rate is 3.64 per cent but the Core rate is 1.32 per cent.
And this is with the ECB buying almost all of the public debt issued since the pandemic and government’s spending a little more freely than before to deal with the health issues.
The assessment is that the Euro experience is not signalling a massive regime shift towards accelerating inflation.
If you think of the propagating mechanisms that might institutionalise these pandemic-driven price spikes – for example, wage pressures – then you would not find them operating in Europe at present.
Another interesting aspect of the movement in prices is the impact of government charges.
In research I have done in previous years (a while ago), I found for Australia that significant movements in the price level (CPI) are driven by government price impacts – the so-called administered prices, which include things like indexed health care charges, indexed utility charges etc.
Eurostat’s – Methodology Manual – explains that:
Administered prices (HICP-AP) are analytical indices that provide a summary of the development of product prices that are directly set or influenced to a significant extent by the government.
The next graph compares the annual rate of inflation for All-Groups and the Administered prices.
Since the pandemic began, the All-Groups index has risen 5.75 points, while the Core index has risen 4.64 points. However, the Administered pricing index has risen by 5.96 points, above the overall index movement.
We also see that the government charges impact has regularly been higher as indexation arrangements chime in.
I expect the Administered price impact to fall a little in the January 2022 data as a result of the expiration of the impact of the increase in the German standard VAT rate which on January 1, 2021 was increased to 19 per cent after being reduced to 16 per cent between July 1, 2020 and December 31, 2020.
The December 2021 observation is the last impacted by that adjustment. My estimates are that it will reduce the Core inflation measure by between 0.35 and 0.4 points.
(iii) Ebaluazioa
What about those propagating mechanisms?
First, there is no evidence that the European Union economies are being over-stimulated.
The latest IMF – Fiscal Monitor (October 2021) – provides estimates of the primary fiscal balance for government from 2012 to the forward-estimates period of 2026 – shown in the following graph.
The austerity mindset is still evident.
Prior to the pandemic the Eurozone Member States together were running primary fiscal surpluses and their response to the pandemic has been much more muted than the other advanced nations.
Further the estimated degree of fiscal retrenchment shown in the forward estimates suggest there is no chance that government deficits will drive accelerating inflation.
Further, the stimulus that has been received over the course of the pandemic will dissipate and cannot drive an inflationary process.
Stay tuned for a resumption of the Excessive Deficits Mechanism, which will further suppress the capacity of governments to add to the inflationary pressure via fiscal deficit expansion.
One also needs to consider the other components of aggregate spending.
And for Europe, the on-going and large trade surpluses are clearly a policy priority and have resulted, in part, from governments (particularly the Northern states) deliberately suppressing the capacity of domestic demand to growth.
Wages growth has been deliberately suppressed to maintain international competitiveness, which means household consumption expenditure is not about to fly away any time soon.
Second, those supply bottlenecks.
The next graph shows the All-groups and Core measures (indexed to 100 in January 2020) and the Producer-price index (from Eurostat).
Between January 2020 and November 2021, the All-groups index rose by 9.9 points, the Core index by 7.7 points and the Producer-price index by 20.1 points.
This is the pandemic effect.
It is not being driven by fiscal or monetary policy settings.
Various essential inputs to production have been in constrained supply – timber, semi-conductors – etc and that supply constraint coupled with difficulties in actually shipping freight around the world have led to these temporary price rises.
Once the pandemic eases and these prices get back to some sense of normality then the inflationary impacts will disappear.
(iv) EBZ-ren analisia
The ECB published an interesting piece of analysis in its Economic Bulletin (issue 6, 2021) – The impact of supply bottlenecks on trade.
They conclude that:
1. “Shipping disruptions and input shortages are leading to considerable bottlenecks in global supply chains” – so goods getting stuck in places they shouldn’t be.
2. “During the recovery phase of the coronavirus (COVID-19) pandemic, households increased their purchases of certain products, such as electronics and home improvement equipment, which caused a stronger-than-expected surge in demand, especially in some sectors” – so a pandemic-driven and specific shift in the composition in spending.
I showed how this impacted on the inflation rate in the US in this blog post – Central banks are resisting the inflation panic hype from the financial markets – and we are better off as a result (December 13, 2021).
3. “coronavirus outbreaks in ports, accidents at plants and adverse weather conditions, led to bottlenecks in the transport sector and caused shortages in specific inputs such as plastics, metals, lumber and semiconductors” – hence the rise in producer prices.
4. “As inventories fell at the onset of the pandemic owing to the running-down of stocks and shortages of inputs resulting from closures and conservative inventory policies, companies struggled to keep up with the swift rise in demand and the replenishing of depleted stocks” – and some firms, with market power took advantage of this situation to maintain profits via higher prices.
5. “Overall, in June the global PMI suppliers’ delivery times index dropped to an all-time low (meaning longer delivery times) since records began in 1999.” (June 2021) – which means that shortages were prolonged.
6. The ECB estimated the “impact of supply bottlenecks on export growth beyond the role played by demand conditions” to be worth around 6.7 per cent in euro area exports and 2.3 per cent globally. That impact is substantial.
Then we come to the debate about regulation.
It is quite obvious that some large firms which can exercise market power (that is, increase prices and maintain sales) are taking advantage of the supply constraints to gouge increased profits.
This situation is not unlike what happens in times of major conflicts, for example, which is why governments introduced various regulations (rationing, price controls) to prevent that sort of predatory behaviour.
Already, the Hungarian government has frozen prices on some food items (sugar, flour, cooking oil, milk products) to reduce the capacity of corporations to take advantage of the supply shortages.
I note, of course, that the government is up for reelection this year!
(v) Ekonomialariak eta inflazioa
Finally, when one considers all these issues, one is left wondering why economists are calling for hikes in interest rates.
We know why?
Because they are ‘one trick ponies’ and have been indoctrinated to think inflation -> monetary policy -> interest rates.
The world has moved on from this obsession with monetary policy dominance.
But think about it for a second.
With spending in danger of falling as governments retrench their stimulus support, with household consumption and business investment spending mute, awaiting more certainty in the future, and exports down due to supply constraints, how does anyone come to the conclusion that making it more costly to borrow money for investment will help.
And how does increasing interest rates, speed up ships, reduce the number of workers in the transport system who are ill from Covid, make ports work more quickly when there are not enough containers available (as they are in wrong ports), improve the weather to stop natural disasters impacting on timber supplies and we could go on?
We just need to be patient and concentrate on getting over the pandemic and then the inflationary pressures will ease fairly quickly.
Ondorioak
(1) When I say that I think the inflationary pressures are transitory, one shouldn’t conclude that means they are short-lived.
(2) Transitory means that there are no institutional measures that are likely to keep the price pressures accelerating once the supply chain bottlenecks ease.
(3) How long that will take depends on the course of the pandemic.
It could be some years.
joseba says:
Inflazioa iraunkorra da
More evidence that the current inflation is ephemeral
(http://bilbo.economicoutlook.net/blog/?p=49030)
When I am asked whether I still consider the recent bout of inflation to be transitory, I say that transitory means as long as the pandemic disrupts the balance between supply and demand. Note: demand. I have been getting lots of E-mails telling me that Modern Monetary Theory (MMT) is a fraud because of the inflation spike and our denial of the demand (spending) involvement. Apparently, the data shows that large fiscal deficits and central bank bond-buying programs are always inflationary. Good try. I last provided data and analysis of this issue in this blog post – Central banks are resisting the inflation panic hype from the financial markets – and we are better off as a result (December 13, 2021) – where I made it clear that the spikes are a unique coincidence between abnormal, pandemic-related demand and supply patterns. That couldn’t be clearer. And when that sort of imbalance occurs, with the addition of cartel-type price gouging (which has nothing to do with fiscal or monetary policy settings) then MMT predicts a nation will encounter inflationary pressures. The idea that the economy is defined by periods below full capacity when there will be no inflation and beyond full capacity when there will be inflation is not part of the MMT body of knowledge. It is more complicated than that dichotomy which we address in our textbook – Macroeconomics. Supporting this view, is a recent ECB research paper, which uses fairly advanced econometric techniques to decompose one measure of inflationary expectations in a component that reflects short-term risk and another that reflects longer term inflationary expectations. They find the former is driving the current inflation trajectory while the latter is largely stable. That means, in English, that the current inflation is likely to be of an ephemeral nature driven by how long the pandemic interrupts supply chains.
In the August 2021 edition – ECB Economic Bulletin, Issue 8/2021 – the ECB publish several special information boxes, which highlight statistical work in areas of relevance and interest.
Box 4 – Decomposing market-based measures of inflation compensation into inflation expectations and risk premia – has a complex-sounding title and uses sophisticated econometric analysis to produce the results, but, the message is simple enough.
The ‘market’ is not expecting inflation to accelerate in the medium- to long-term and the factors driving inflationary pressures in the immediate period are considered transitory and related to the massive disturbances that the pandemic has wrought.
Trying to build a narrative that these factors are directly related to irresponsible fiscal and monetary policy settings designed to protect employment and incomes in the short-term while the pandemic rages on is an impossible task.
The overall theme of Issue 8 is to juxtapose the current ECB policy settings – stable and low interest rate with massive bond-buying program – with the economic conditions that are evolving as we move through the pandemic, especially since the arrival of the Omicron variant.
They find:
… economic activity suggest that growth momentum remained weak at the start of the fourth quarter, particularly in the manufacturing sector owing to the above-mentioned supply bottlenecks, whereas the services sector benefited from the reopening of large economies.
The ECB revised its future growth estimates downward in its December 2021 Eurosystem staff macroeconomic projections for 2021, in part, because of the “adverse impact of the ongoing supply bottlenecks on global imports” which they predict will “start easing from the second quarter of 2022 and to fully unwind by 2023”.
The combination of on-going supply constraints with recovering demand means that prices are rising as long as the imbalance persists.
As they say:
The future course of the pandemic remains the key risk affecting the baseline projections for the global economy.
That is the basis of treating trends as being transitory for now given that no institutional structures appear to have formed that could act as a persistent propagating mechanism to drive a structural inflation bias, in the same way that the wage-price battles of the 1970s did after the oil price hikes.
More specifically, the ECB concurred that:
Inflation is expected to remain elevated in the near term, but to decline in the course of this year. The upswing in inflation primarily reflects a sharp rise in prices for fuel, gas and electricity. In November, energy inflation accounted for more than half of headline inflation. Demand also continues to outpace constrained supply in certain sectors. The consequences are especially visible in the prices of durable goods and those consumer services that have recently reopened.
Importantly, they demonstrate that “Market and survey-based measures of longer-term inflation expectations have remained broadly stable”
How do financial markets tell us anything about the likelihood of inflationary pressures.
One popularly-used measure is the inflation-linked swap (ILS) rates, which are considered a proxy for inflationary expectations.
The five-year, five-year ILS is widely used as an indicator of short- to medium-term expectations of price movements, while the ten-year, ten-year ILS is the long-term inflationary expectation.
When an ILS contract is made between two parties, one party agrees to pay a fixed cash flow on some nominal principle while the other party agrees to pay a floating rate that is directly linked to some inflation index like the CPI.
The intent is to transfer the inflation risk through the fixed cash flows from one party to the other. The hedging party is willing to pay to reduce their uncertainty, while the other party speculates on the inflation trajectory.
If the inflation rate over the course of the contract is higher than the swap rate, then the person paying the fixed rate profits and vice versa.
The ECB note that the 5-Year, 5-Year rates have risen over 2021 as “sustained supply chain tensions, rising energy prices” etc although there is mixed evidence for other indicators.
They assess that the “markets are pricing in a rise in euro area inflation over the short term”.
But how persistent is this ‘pricing’ sentiment?
Not very according to the same data.
The ECB note that:
At the same time, they are still pricing in the rise in inflation as transitory, with the one-year forward ILS rate one year ahead standing at around 1.7% and the five-year forward ILS rate five years ahead slightly higher at 1.8%.
Which brings me to the research box the ECB provided to clarify this further.
In Box 4 – Decomposing market-based measures of inflation compensation into inflation expectations and risk premia – there is a statical decomposition of the inflation-linked swap rates (ILS) performed, which separates out factors associated with risk premia from those associated with shifting expectations.
The conclusion is clear – the rise in the ILS rates:
… is mainly related to a shift in the inflation risks priced in, from lower than expected to higher than expected.
What does that mean?
It means that in the longer-term, the characters who try to make money using these financial instruments do not expect accelerating inflation.
The ECB provide this graph (first panel of Chart A) which shows the evolution of the different ILS rates in the euro area (1 year, 5 year and 10 year).
It shows that while ILS rates “were relatively stable from 2005-07” they plunged during the GFC (as inflation fell dramatically) and then again during the early period of the pandemic (March 2020).
As the supply constraints tightened, the ILS rates started to rise, with the shorter end rates rising more quickly and to a higher level than the medium- to longer term rates.
Note that the longer rates are only around 2 per cent, which most central banks consider to signal price stability.
The ECB note though that the ILS rates “reflect not only financial market participants’ actual inflation expectations, but also inflation risk premia”.
We know that when there are major supply disruptions, inflation risk premia among risk averse financial market participants rise sharply.
With demand shocks, the opposite is usually observed.
Why?
In the case of supply bottlenecks, traders who are seeking real payoffs and demand higher risk premia in these swap contracts.
I won’t detail the econometric techniques that the ECB researchers used to separate out these two drivers of the ILS swap rates.
Suffice to say they are standard and I have no issue with them.
The modelling finds that the “short-term ILS rate converges on a fixed number over the long run” (which is a statistical property of these sorts of stationary term structure models).
They calibrate that rate to 1.9 per cent.
The overall conclusion is that:
… inflation expectations are in general more stable than ILS rates, and that inflation risk premia across tenors have changed sign in the past, including recently.
What that means is that the financial markets have been adjusting their inflation risk premia over time.
The premia went negative in 2013-14 as “markets increasingly accounted for the risk of inflation outcomes falling below their expectations”.
In the recent pandemic period, the risk premia estimates have risen as the economies resume higher levels of activity within a tightly constrained supply side and the premia are now positive.
The ECB conclude that financial market participants are:
… pricing in of a greater likelihood, or at least risk, of the economy being dominated by supply shocks in the foreseeable future in the context of ongoing supply bottlenecks.
We know that these bottlenecks will ease once the pandemic eases.
And then the risk premia will switch sign again and ILS rates will fall sharply again.
Ondorioak
While this material might be difficult for some to follow, the upshot is fairly simple.
There is no firm evidence that participants in the financial markets who make bets based upon their desire for real profits (that is, insulated from inflation effects on the value of money) believe that inflation is set to accelerate and be higher over a medium- to long-term period.
They are assessing that the increased spending as the economies reopen running up against the on-going supply constraints are making trading riskier but that risk is largely short-term in nature.
The evidence suggests that once the supply-side eases and different sectors (such as the goods-producing and the services) resume some sense of normality and shipping and air freight adjust that these risks will diminish.
That is, further evidence that my assessment that the inflation spikes at present are ephemeral.
But ephemeral might not mean a few days or months in duration.
It all depends on how persistent the pandemic proves to be.
joseba says:
Covid-eko inflazio presioak nagusiak dira baina iragankorrak
Bill Mitchell-en Covid-specific inflationary pressures are dominant and are transitory
(http://bilbo.economicoutlook.net/blog/?p=49191)
There has been some very interesting data and other research published recently that allow us to more fully understand what is driving the current inflationary pressures. There is a massive lobby now pushing the idea that the central bank bond-buying programs and the rising fiscal support during the pandemic are responsible. This sort of narrative is coming from the mainstream economists who are suffering attention-deficit disorders (even though they get the top platforms all the time to preach their views), and, who in the last few weeks have become increasingly vehement and personal in their attacks on Modern Monetary Theory (MMT). Their actions are a sign that the cognitive dissonance is getting to them and they realise they have been left behind. But the evidence that is continually coming out across a number of indicators continues to reaffirm my view that the current inflationary spikes are being driven by the total abnormal circumstances the world has found itself in as a result of the pandemic. The usual institutional and structural drivers of an inflation – which were certainly prominent in the 1970s – seem to be absent at present. I will present further research next week on this topic as I build further evidence.
ECB admit interest rates rises do not work
The ECB conducted a Twitter Q&A yesterday (February 10, 2022) with Executive Board member Isabel Schnabel answering the questions.
Several answers were telling.
1. “Inflation has risen mainly due to energy prices which we cannot affect directly. But we are seeing that inflationary pressures are broadening and becoming more persistent. Policy optionality is therefore more important than ever.”
2. “If there is a risk that inflation expectations become unanchored, we need to take action even if the shock is exogenous. Currently, longer-term inflation expectations remain well-anchored.”
3. “Due to lags in policy transmission “transitory” shocks typically do not require policy action. They matter for monetary policy when there is a risk that they become entrenched in expectations, requiring policy action to protect price stability.”
4. There was this interesting exchange:
5. “ECB simulations show that the stock of assets acquired under APP and PEPP will put sizeable downward pressure on interest rates across the maturity spectrum for the years to come.”
6. “In the 1970s rising oil prices triggered a harmful price-wage spiral, as inflation expectations drifted away. Today longer-term inflation expectations are well-anchored. We will ensure that high inflation does not become entrenched.”
7. “The empirical link between money growth and inflation has weakened over recent decades. Inflation developments depend on the transmission of policy measures to the real economy, which hinges, for example, on the state of the banking sector.”
8. “Raising rates would not lower energy prices. But if high current inflation threatens to lead to a de-anchoring of inflation expectations, we may still need to respond, as our mandate is to preserve price stability.”
9. “What matters for inflation is the growth in wages over and above productivity growth. We carefully monitor wage developments as they are crucial for the inflation outlook”.
So what you get from all that is effectively what I have been writing about for the last year when I discuss inflation.
Interest rate increases are not appropriate when OPEC is using its cartel power, or workers are sick from Covid and cannot deliver or produce goods and services, or lockdowns stop service purchases and boost goods purchases and the supply-side cannot respond quickly enough.
The following graph shows the long-term inflationary expectations from the – ECB Survey of Professional Forecasters First quarter of 2022.
The long term inflationary expectations (for 2026) have risen over the course of the pandemic but are still below 2 per cent (1.97 per cent in January 2022).
There is no break-out evident.
This graph (taken from Chart 4 of the ECB SPF) reinforces that conclusion. It shows the distribution of the point estimates of inflation across the survey group.
The concentration between 1.8 per cent and 2.0 with a shift towards 2 over the last 3 quarters tells me that this group is not forecasting an inflation outbreak over the next 4 years.
I can also note that the Euro 5-year, 5-year inflation swap rate has been declining recently, which also accords with what is happening in the US.
Speaking of which – here is the graph for the ‘5-year, 5-year forward inflation expectation rate’ in the US (daily data) which measures “expected inflation (on average) over the five-year period that begins five years from today”.
The data runs from January 2003 to yesterday, February 9, 2022.
The series most recent peak was on October 15, 2021 (2.41 per cent) and has been on a consistent downward trend as the nature of the current price pressures becomes more obvious.
I caution though.
In its July 2006 Monthly Bulletin article – Measures of Inflation Expectations in the Euro Area – the ECB noted that:
Inflation-linked swap quotations are an additional source of information about market participants’ inflation expectations … The resulting inflation-linked swap rates should, therefore, not be interpreted as direct market expectations of future inflation rates.
There is also mixed survey evidence.
So at least in Europe and the US, there is no breakout of inflationary expectations, which might drive the supply constraints into a generalised inflation.
So this part of the story looks to support the transitory, supply-side interpretation, I have been offering for more than a year now.
The labour market
The European Commission conducts regular – Business and consumer surveys – and one of the questions they ask business firms relate to “Factors limiting production”.
In their – January survey – they found:
Reports on shortage of material and/or equipment as a factor limiting production climbed to the highest quote on record (+3.6pp to 50.8% of all industry managers). These production constraints are compounded by shortage of labour force, with a record 25.9% (+2.4pp compared to October) of managers identifying labour shortages as a limiting factor for production …
Capacity utilisation in services decreased …
They produced this graph (Graph 11 EU Capacity Utilisation) which tells me that there is still excess productive capacity available across European firms – which, in turn, tells me that this is not a demand-driven price episode.
Further, I consulted the most recent data for ‘negotiated wage rates’ for the Euro area, which gives a good indication of wage pressures coming from organised labour bargaining.
Refer back to Isabel Schnabel’s answer (quote 9 above) about ‘what matters for inflation’.
Data is available from the Eurostat and the ECB (Source) from the March-quarter 1991 to the September-quarter 2021.
Here is a graph of the annual growth in negotiated wages.
To help you understand the implications, I repeat what I have often written.
If labour productivity growth is growing at say x per cent per annum (which reduces unit labour costs) then nominal (money) wages can grow by the same rate without putting any cost pressures on the rate of inflation.
Average labour productivity (output per hour) has been 2.2 per cent over the period March-quarter 1995 to September-quarter 2021. Over the 12 months to the September-quarter 2021 it averaged 4.5 per cent (Source).
So using the long-term average as a guide to discern the available inflation-free headroom for wages growth, and, given the ECB is targetting a 2 per cent inflation rate, then wages can grow at around 3 to 4 per cent per annum without there being any significant inflationary impacts.
The graph shows that not only is the rate of growth in negotiated wages falling, it is now down to 1.36 per cent, which means that not only are real wages falling (hardly a sign of a demand boom) but the gap between productivity growth and wages growth is rising.
Again, experts look at this data and conclude there is not a demand-side (overspending) dynamic driving the inflation trajectory.
The supply constraints
The San Francisco Federal Reserve Bank conducts very interest – Economic Research – and one of the current projects is to study the – Inflation Sensitivity to COVID-19.
They provide decompositions of the growth in US inflation (core personal consumption expenditure – PCE – measure) that can be traced:
… to the economic disruptions caused by the pandemic.
They write that the “PCE measure of U.S. inflation is considered particularly useful for identifying underlying inflation trends.”
It excludes the short-run volatility coming from “food and energy products”.
They calculate “sensitive and insensitive components”, where:
COVID-sensitive components include those categories where either prices or quantities moved in a statistically significant manner at the onset of the pandemic, between February and April 2020. COVID-insensitive components include all other core PCE categories.
They produced this really interesting graph (Chart 1 from the FRBSF research).
The interpretation is pretty clear.
Inflation is being driven by Covid-specific effects and when they are attentuated (if) then what is left is low and pretty stable inflation.
They also present a breakdown of the Covid sensitivity into demand and supply components, which I will write about another day when I have more time.
You can learn more about this research from:
Shapiro, A. (2020) A Simple Framework to Monitor Inflation, FRB San Francisco Working Paper 2020-29. https://doi.org/10.24148/wp2020-29.
Conclusion
I am maintaining my view that the current inflationary spikes are being driven by the total abnormal circumstances the world has found itself in as a result of the pandemic.
The usual institutional and structural drivers of an inflation – which were certainly prominent in the 1970s – seem to be absent at present.
So the assessment – Transitory – remains.
And repeating, that doesn’t mean short-term. Transitory means as long as the special circumstances are present.
The risk is the longer it takes to resolve the pandemic, the more likely some of those institutional and structural forces might emerge. I doubt it though.