Eurozone: Inflation, the guest we could have done without

There is no inflation in Europe, just a rise in energy and food prices that should be analysed as an exogenous shock that monetary policy is unable to counter. Fears over second-round effects, i.e. salary adjustments in reaction to the rise prices, are baseless. The abundance of labour in the world is holding back salary formation, not just in emerging countries but also in advanced economies, by raising concerns over worker relocation. In any case, the expected slowdown means that this threat should be avoided. Given the outlook for deteriorating activity levels in the euro-zone, the ECB would have done better to follow the Fed down the rate-cutting path. Such are the arguments most frequently aired by critics of the ECB, and they seem to form a “single doctrine”. All these arguments can be refuted.

 1 – The analysis which asserts that the acceleration in prices is exogenous in the US, Europe, Japan, China, India… and all countries that import energy might lead one to wonder whether the increase might not come from another planet! We might add that when a price index (which is an average) rises, some of its components naturally increase more than others! 2 – The “second-round” effects have not materialised, but that does not mean that they have receded. To prevent them from appearing, it seems crucial that the monetary authorities must act so that price expectations remain properly anchored. We know that, irrespective of its origins, once a price/salary spiral is created, it fuels inflation, which becomes very costly to eradicate, as shown by experience at the turn of the 1970s/1980s. Consumers’ expectations are very sensitive to prices of products that they buy on a recurrent basis (food, energy), and these are the very ones that are known to be rising the most rapidly at the present time. The European Commission’s monthly survey shows that households’ expectations of rising prices have increased strongly in recent months: the balance of responses referring to inflation in the next twelve months has risen from 19.4% in June 2007 to 30.6% one year later. The view that salary formation is not affected by this is not entirely borne out by the data. Remuneration has shown an accelerating trend in the recent period, involving not just the increases awarded in Germany, but also the consequences of salary indexation, which is still applied automatically for around 15% of euro-zone employees and more loosely for around 20%. Similarly, the statistic for negotiated salaries shows an increase of 2.8% for the first quarter of 2008 compared with 2% one year earlier. The downward pressure from emerging countries is significantly less marked than in the first half of the decade. The production of goods to be exported from

emerging countries has become more costly, because of intermediate consumption prices (raw materials) but also currency appreciation (even if limited) in several of these countries and a sharp increase in salaries (18% in Chinese cities). In the financial markets, the implied inflation derived from a comparison of yields on traditional and indexed bonds works out at 2.6% compared with 2.1% one year ago. 3 – One might naturally think that the slowdown expected in the euro-zone would hold back salary formation. This would be to ignore the fact that the European economy lacks the flexibility of its US counterpart. Salaries in the euro-zone are significantly less sensitive to conditions in the labour market, or in other words, the Phillips curve is flatter. Moreover, the employment market is less quick to adjust to economic activity trends; in other words, the economic slowdown translates more easily into a cyclical brake on productivity gains than is the case in the US. On a year-on-year basis, growth in the hourly productivity of labour has moved from 1% to 3% in the US, while falling from 1.6% to 0.5% in the euro-zone. The result is naturally an acceleration in unit labour costs (2.4% in the first quarter of 2008, 1% one year earlier), above the level of underlying inflation and the ECB’s target. 4 – The euro-zone is not a small country: its weight in the world economy is comparable to that of the US. By tightening its monetary policy, it is making its contribution to the worldwide fight against inflation. Its actions carry a message for hesitant peers, in the first place emerging market central banks, but also the Fed which now seems to be thinking that the benefits of a low dollar are cancelled out by the disadvantages (in recent years, a strong correlation has been established between on the one hand falls in the dollar relating to interest rate expectations, and on the other rising oil prices).

Philippe d’Arviisenet

One Response to "Eurozone: Inflation, the guest we could have done without"

  1. Guest   July 21, 2008 at 10:24 am

    The fact remains that hiking interest rates in the face of a negative oil supply shock does not help either aggregate supply nor aggregate demand. In fact, the entire economy is worse off compared to the status quo. This is what tanked the economy in the 80s, not inflation per se. There’s no denying that the ECB is part of the problem, not the solution.