Inflationary tendencies herald a monetary normalisation

The general assumption is that the European Central Bank (ECB) will scrap its unconventional monetary policy in 2018. However, the current low inflation figures give the ECB a strong argument for continuing the stimulus. Nevertheless, there are a number of inflationary tendencies in the eurozone lurking behind the low inflation, and they will gain strength in coming months. Too much caution in the monetary policy could cause considerable damage to the European economy. The ECB will have to come up with strong arguments with which to fundamentally defend its change in policy. The return of inflation and the underlying structural developments will be the economic theme of 2018.

At the beginning of the new year, a great many new statistics and predictions are strewn around. They too reiterate that economic growth is accelerating worldwide. The IMF now expects as much as 3.9% actual GDP growth in 2018 and 2019. The surprisingly strong performances by Europe, in particular, really stand out. We expect a final actual growth figure of at least 2.4% for the eurozone in 2017. At the same time, new figures from Eurostat demonstrate a stubbornly low inflation in the eurozone (1.4% in December 2017) – substantially lower than the goal set by the European Central Bank (ECB). In principle, a higher rate of inflation is a major precondition to scrapping the stimulating monetary policy. The general opinion is that the ECB will start a gradual run-down of its unconventional monetary policy later this year, by discontinuing its purchase programmes. Social and economic criticism of the side effects of this policy is increasing, while the current strong growth performances remain difficult to reconcile with an exceptionally stimulating policy. The recent fluctuation in the German long-term interest rate shows that the markets are gradually incorporating this policy change. The recent downturn in the inflation in the eurozone would appear at first sight to contradict the expected change to the monetary policy.

It seems unlikely that the inflation in the eurozone will effectively evolve towards the goal of 2% in the coming months. That could essentially cause the ECB to decide to maintain the monetary stimulus at the same level for longer. However, despite being perfectly justifiable in terms of economic efficiency, this scenario seems unlikely – or probably even a crucial error of judgement. In spite of the relatively low inflation, we are still seeing more and more signs of inflationary tendencies in the European economy. These inflationary tendencies are not as yet manifesting as effective inflation, because they are being compensated for by a number of deflationary tendencies. However, the inflationary tendencies will ultimately prevail and cause a rise in inflation, but probably not until after the effective normalisation of the monetary policy.

This is not just a matter of semantics as the world economy is currently facing a number of complex and contradictory processes. They ensure that the traditional economic laws assert themselves only slowly, but they are more important than ever in correctly estimating the current situation.

The first inflationary trend we can confirm, is the continuing improvement in the world economy’s growth, particularly in Europe. At the current growth level, we can no longer speak of an economic recovery in Europe (after the crisis), but rather of true economic expansion. The current economic growth is clearly higher than the potential growth of the eurozone (roughly 1.2%), a theoretic concept that measures the possible growth, given the current product means in our economy. Calculation of the potential growth is subject to criticism for valid reasons, but the strong current growth performance obviates that discussion. Exceeding the potential ultimately leads to inflation and a slowdown in the economic cycle. The current situation can be seen as heralding effective inflation in the eurozone.

On the other hand, capacity utilisation in the European industry is clearly increasing. Optimism and solid export performances in the industry had a positive impact on European growth in 2017. However, there are no inflationary tendencies in industrial products, mainly due to constant American and Chinese industrial overcapacity. The combination of worldwide overcapacity and fierce international competition continues to exert a downward pressure on industrial prices. Any international trade conflict (between the US and China, for example) could break this deflationary spiral. Such a scenario cannot be ruled out in the coming years.
However, the importance of industrial products to the eurozone’s inflationary figures is limited (26%). By contrast, prices for services determine 45% of inflation. Those prices are mainly determined by the evolution in European wages. International competition in services is also more limited. This means that there is a crucial role to be played by the European labour markets in 2018. Wages were under pressure throughout all of Europe during and after the financial crisis. Now, however, falling unemployment and the increasing employment rates in the eurozone are exerting an upward pressure on European wages. In the majority of eurozone countries, wage growth is accelerating, which is further strengthened by shortages in certain segments of the labour market (shortage professions and the highly skilled, for example). The demand for labour is reinforced by the strong economic climate, so wage growth is likely to continue in the coming months. This is a third – and possibly the most important – inflationary tendency taking shape at present.

Lastly, there are signs of inflationary tendencies occurring in many markets worldwide. The strong economic recovery is confirmed by the sharp rise in the prices of oil and other raw materials. Naturally, energy prices will contribute to the increase in inflation, but higher prices for energy and raw materials will also be indirectly reflected in prices of final goods and services. The strong performances by most financial markets (equity, real estate, …) do not directly affect inflation, but an inflationary impulse in the form of higher disposable income (from capital gains) and rising rent prices, is an indirect result of those performances.

The ECB adopted a cautious attitude at the end of 2017. By extending the quantitative easing until the end of September 2018 (albeit reduced to 30 billion euros per month) the ECB has, above all, bought time. However, in spring 2018, the ECB will have to communicate about the way forward for monetary policy. Given the inflationary tendencies, and despite the overly low inflation, the time is ripe for the ECB to shut down its purchase programmes, but it will have to present strong arguments and convincing figures. After all, the ECB’s reputation is on the line. Continued caution threatens to push recovery in the eurozone towards overheating. In the end, the ECB’s enormous balance sheet – the result of the massive bond purchases – and the low interest rate are still major stimuli for the real economy.

In any event, 2018 will be the ‘year of inflation’ in debates, discussions and, in particular, in facts. The long-awaited return of inflation is imminent.