Eurozone - Inflation Not 'Relatively Vigorous'

Messaging is taken as a crucial part of the central bank governor’s job, so we can’t be sure that headline writers and bond markets got it wrong this week when they latched on to ECB governor Mario Draghi’s description of Eurozone headline inflation as ‘relatively vigorous’. He did, after all, tell the European Parliament that ’underlying inflation is expected to increase further over the coming months as the tightening labour market is pushing up wage growth’.

In fact, the headlines belied Draghi’s rather drab forecasts: ‘Annual rates of HICP inflation are likely to hover around current levels in the coming months and are projected to reach 1.7% in each year between now and 2020. This stable profile conceals a slowing contribution from the non-core components of the general index, and a relatively vigorous pick-up in underlying inflation. Reflecting these dynamics, the ECB projections foresee inflation excluding food and energy reaching 1.8% in 2020.’

Given that in August, headline CPI was running at 2%, it is plain that ECB thinks headline inflation has already peaked, despite a modest uptick in core inflation (currently 1%). In general terms, that conforms with what one would expect if the deflections from 5yr seasonalized trends seen over the last six months are maintained. And given that those 6m deflections are already running at 0.8SDs for headline inflation and 0.9SDs for core inflation, these are already pretty punchy short-term forecasts.

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In fact, it remains very difficult to make a case for a sustained uptick in the Eurozone’s inflation picture, with even the ECB’s longer-term steady-state at 1.7% looking hard to justify.

Rather, what evidence we have, including labour market evidence, gives no real hint that we are at an upward inflection point in Eurozone inflation. That evidence encompasses the state of inflationary expectations; the continued inability to pass through rises in factory prices to the consumer; and, crucially, labour market and wage trends.

First, consider expectations. Unlike in the US, where the inflationary expectations curve is now inverted, surveyed expectations in the Eurozone continue to expect a very modest uptick in inflation. On a quarterly basis, the ECB surveys professional forecasters, and compares that with consensus economics, and the European Commission’s monthly survey of consumer expectations: over a 2yr period, the expectation is for inflation of 1.6%-1.7%, with longer-term expectations of 1.8%-1.9%. These longer-term inflation expectations are almost entirely unchanged over the past four years.

But not only are longer-term expectations unchanged, they have fallen relative to 1yr inflation expectations. The Eurozone inflation expectations curve has not inverted, but is has quite clearly flattened over the last few years. Expectations, in other words, are an increasing damper on inflation, not a driver of it.

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Second, there is no observable improvement of the ability of retailers to pass through increases in factory prices to consumers. Looking at the difference between monthly rises in PPI and monthly rises in CPI produces a CPI/PPI terms of trade. When it is rising, as it did between 2013 and 2016, it implies an improving ability of distributors of final goods and services to raise their margins. If there is underlying inflationary pressure from their suppliers, they are able to pass it along. But when the line falls, the reverse is true (ie, increased costs can’t be passed on to the consumer).

Since early 2017, the line has been stable, suggesting cost increases can be passed on, but final distributor margins are not rising. There is, in other words, consumer resistance to higher prices. As one would expect if underlying inflationary expectations are in retreat.

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The most curious feature of Mr Draghi’s presentation, however, was the apparent belief that inflation will be bolstered by wage pressures. This seems, on the face of it, utterly remarkable: the Eurozone’s unemployment rate is still above 8%: can it really be the case that the Eurozone’s labour market and supply-side rigidities are such that wage inflation kicks in at 8% unemployment? If so, the Eurozone is an extraordinary international outlier. The US unemployment rate of 3.9%, the UK rate of 4%, the Japanese rate of 2.5%, none of these has so far proved the foundation for inflationary wages rises.

If there is one economy within the Eurozone where this argument might develop some purchase, it is Germany, where the strictest definition of unemployment puts the rate at 3.4% (though the Bundesbank prefers a more generous figures of 5.2%).

But even in Germany, it is impossible to make the case that current wage rises are a potential source of inflation. In 2Q18, gross average monthly earnings growth was running at 2% yoy in Germany, which, deflated by CPI implies no real growth at all. Meanwhile, real GDP per worker was growing at 0.9% yoy. In other words, current wage rises are not even keeping up with productivity rises: if this continues for the medium term, the supply produced by Germany’s workers would therefore be rising faster than those worker’s ability to consume the product without either eroding savings or borrowing. Far from being inflationary, current wage settlements in Germany are currently disinflationary for the first time since 2012!

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Conclusion: If the Eurozone is about to see a modest sustained uplift in inflation, it will have to do so in the teeth of the underlying trends in wages vs productivity in its dominant economy.