TIME TO GET REAL ON EUROPE´S INFLATION TARGET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Time to get real on Europe’s inflation target

By Wolfgang Münchau

Published: January 30 2011 21:38

Should we worry about inflation in Europe? Or rather: should we worry about inflation in the presence of an inflation target of under 2 per cent? The European Central Bank has been warning about the inflationary effects of higher commodity prices. For a central bank that takes its target seriously the concern is justified. But higher food and energy costs are not even the biggest problem. A clearer and more present inflationary threat would be an overheating German economy at a time when peripheral Europe is in a depression.


Is Germany overheating? It is hard to come to that conclusion from the actual levels of real gross domestic product. Between the third quarters of 2007 and 2010, seasonally adjusted quarterly German real GDP fell by 0.2 per cent, according to Thomson Datastream, while it rose by 0.1 per cent in the US. So how can it be overheating when it has not even reached the pre-crisis level of output? It would certainly be a sign of extraordinary structural weakness if that were to happen. And Germany, so we are told, is very strong.


For Germany, this is the first cyclical recovery in decades that begins with a comparatively low level of unemployment. In August 2007, seasonally adjusted unemployment was still relatively high at 8.9 per cent. The rate fell to 7.6 per cent a year later and rose to only 8.3 per cent during the 2009 recession. Companies used imaginative short-time work schemes to keep their workers on board. The unemployment rate has since come down to 7.5 per cent.


That is very good news for German workers. But due to an export-based industrial monoculture, Germany is vulnerable to labour supply shortages. In December, the shortage of graduate-level engineers rose by 6 per cent, double what it was a year earlier. The Association of German Engineers, which monitors the labour market situation within its profession, said the rate of increase in labour shortages was frightening, and it expects it to get worse. The gap was accounted for by mostly two sectors – mechanical and electrical engineering.

Average German labour costs will be contained in the current year because some of last year’s wage agreements run into this one. The economy also still generates new low paying jobs that bear down on average wage costs. This effect, which stems from welfare reforms, is not going to last forever. I expect this year’s wage round to produce big wage increases, putting pressure on average unit labour costs from next year onwards.


Where would this leave the eurozone? Until now, German inflation has been consistently below the eurozone average. But the situation is about to reverse. This will make the adjustment process in the European periphery progressively harder – if you factor in the ECB’s likely policy response. Because of price-indexing mechanisms, I expect Belgium and Italy to produce inflation rates at least as high as Germany’s. So the combination of an overheating German economy, indexations and commodity price rises might bring a persistent increase in eurozone inflation.


This is my best guess: a German inflation rate rising slowly towards 4-6 per cent over the next two years, which would be consistent with a rate of nominal annual GDP growth of about 6-9 per cent. The eurozone data would be a little lower, perhaps 3-5 per cent for inflation, and 5-8 per cent for nominal growth.

This is not a prediction, merely what I consider plausible on the basis of current market expectations of future interest rates.


Where would this scenario leave monetary policy? If the ECB is determined to stick to its inflation target, it will need to raise interest rates soon. It is probably best to think in terms of insurance – a central bank is ready to pay a premium to prevent large deviations from the inflation target.


From a pure monetary policy standpoint, the least risky option is a moderate rise right away, followed by a few further rate increases during the year. That would depress average growth. It may even drive the eurozone periphery over the edge. But it would probably not produce deflation for the eurozone as a whole. If the ECB leaves rates unchanged for another year, it will risk an inflationary overshoot later. It would then take a crippling increase in nominal interest rates to bring inflation back to under 2 per cent. We are talking about rates in the higher single digits. Just imagine what such a scenario would do to the Spanish, or even the German, banking sector?


There are other options. The ECB might allow some target slippage, but somehow I do not think that is going to happen. I have always felt that an inflation target under 2 per cent was too strict for a monetary union with as much price stickiness as the eurozone.


This target was one of its many birth defects. It did not matter much last decade when Germany was undershooting the eurozone inflation average. But when Germany overshoots, in a continuing financial crisis, such a target is as unrealistic as a no bail-out clause.


So should we worry about the return of inflation? The answer is yes and no. No, if the target were more realistic, and yes otherwise.


Copyright The Financial Times Limited 2011