FLASH ECONOMICS. Are there good reasons not to accept 1% inflation in the euro zone? ECONOMIC RESEARCH

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1 ECONOMICS ECONOMIC RESEARCH 7 November - No. 9 Are there good reasons not to accept % inflation in the euro zone? The ECB is going to adopt an even more expansionary monetary policy, with the risks that entails, to bring euro-zone inflation closer to the % target. Observation of core inflation and labour costs, shows that euro-zone inflation can be expected to stabilise in 6-7 at around %. Are there good reasons not to accept this % inflation? It does not create any distortions or a deflationary situation: Real interest rates are low; Real wages are not increasing abnormally relative to productivity; The relative price of services compared with manufactured goods continues to reflect the gap in productivity gains between manufacturing and services. The only argument in support of inflation exceeding % is therefore as follows: if inflation remains at %, the ECB's interest rates will remain very low even when they have been normalised, and the ECB could only lower its interest rates very little if that became necessary in the future due to another recession. Author: Patrick Artus

2 Even more expansionary monetary policy in the euro zone Observation of core inflation in the euro zone and increases in the unit labour cost (Charts A and B) shows that if the oil price remains stable, euro-zone inflation will converge towards about % in 6-7, but not higher. Chart A Euro zone: Inflation (Y/Y as %) Chart B Euro zone: Unit labour cost (Y/Y as %) Inflation (CPI) Underlying inflation (core* CPI) 8 8 (*) excl. energy and food 6 6 Sources: Datastream, Eurostat, Natixis This will lead the ECB to conduct an even more expansionary monetary policy, probably quantitative easing on a larger scale (Chart A), and to lower the banks' deposit rate (Chart B). 8 Chart A Euro zone: Monetary base (in EUR bn) 8 Chart B Euro zone: Euro repo rate and interest rate on banks' deposits at the ECB (as %) 6 6 Euro repo rate Interest rate on banks' deposits at the ECB Conducting this very expansionary monetary policy involves obvious risks: due to excess liquidity, increased volatility of asset prices; due to the magnitude of purchases by the ECB, difficulty for investors to find the assets that they need; abnormal tightening of risk premia on the assets purchased by the ECB (peripheral euro-zone debt, covered bonds). For the ECB to take these risks, it must logically think that accepting inflation of only % in the euro zone would be a serious mistake. So let us consider whether there are sufficiently strong reasons not to accept inflation of only % in the euro zone. Flash 9 -

3 Are there serious disadvantages entailed by inflation of only % in the euro zone? The first risks which come to mind, linked to inflation of only % in the euro zone, are the risks of distortion entailed by very low inflation: an abnormal rise in real interest rates, abnormal growth in real wages, impossibility for relative prices to be sufficiently distorted. But these distortions are not perceptible. () Real interest rates in the euro zone are not abnormally high, despite the low inflation (Chart A); in the recent period, real interest rates have been lower than real growth in the euro zone (Chart B). This shows that there has not appeared a situation of the deflationary type with abnormally high real interest rates in the euro zone. Chart A Euro zone: Real interest rate (deflated by CPI, as %) Chart B Euro zone: Real GDP growth (Y/Y as %) Real euro repo rate Euro zone excl. Greece: real -year govt. interest rate Sources: Datastream, Natixis Sources: Datastream, Eurostat, Natixis () Real wages in the euro zone are not increasing in an abnormally rapid manner despite the low inflation Another deflationary characteristic would be one in which real wages increase too quickly relative to productivity, due to low inflation and the stickiness of nominal wages. But this cannot be seen in the euro zone either: in the recent period real wages have increased less than productivity (Chart A) as a result of the slowdown in nominal wage growth (Chart B). Chart A Euro zone: Per capita real wage and productivity (Y/Y as %) Real per capita wage (deflated by GDP deflator) Per capita productivity Chart B Euro zone: Nominal per capita wage (Y/Y as %) Flash 9 -

4 () The third risk is distortion of relative prices If headline inflation is very low, the prices of the various types of goods and services cannot decline much relative to prices as a whole if those prices cannot fall. Let us take the case of the relative price of services compared with manufactured goods; the relative price of services should increase because productivity gains are lower in services than in manufacturing. But the lower the price of goods as a whole, the harder it is to push down the relative level of manufacturing prices, unless the goal is to push down prices of manufactured goods. Chart A shows growth in labour productivity in the euro zone, in manufacturing and in the rest of the economy. Chart B shows the trend of the value added deflators for manufacturing and the rest of the economy; Chart C shows growth in the consumer prices of services and manufactured goods. The value added deflator for manufacturing is boosted by the fall in commodity prices. Chart A Euro zone: Per capita productivity by sector (Y/Y as %) Chart B Euro zone: Value added deflator by sector (Y/Y as %) - Manufacturing sector Non-manufacturing sector - Manufacturing sector Non-manufacturing sector Chart C Euro zone: CPI (Y/Y as %), Manufacturing,, Services,,,,,,,,,,,,, -, , So let us examine consumer prices. We can see that the rise in the relative price of services compared with manufactured goods in the euro zone corresponds to the average gap between productivity gains in manufacturing and services: the low level of inflation in the euro zone does not prevent the necessary distortion of relative prices. Flash 9 -

5 Conclusion: So there remains only a single drawback associated with inflation of only % in the euro zone The ECB is prepared to take the risks entailed by a very expansionary monetary policy to try to prevent euro-zone inflation from rising to around %, and not beyond. The disadvantages entailed by inflation of only % in the euro zone must therefore be serious. But we can see that the distortions that could be related to low inflation are not present: Real interest rates in the euro zone are not too high; Real wages in the euro zone are not increasing too fast; Relative prices are normally distorted. If these distortions are not present, the only disadvantage related to inflation of only % in the euro zone is as follows: if inflation is very low, the monetary policy rates of the ECB, even normalised, will likewise be very low. If, in the future, the euro zone enters into recession again, then the ECB would have very little leeway to lower interest rates: the higher the level of inflation at the end of a period of expansion, the more the central bank can lower interest rates before being faced with the zero lower bound in nominal interest rates. It is therefore necessary to boost inflation above % to avoid practically not being able to use monetary policy in the euro zone in the future. Flash 9 -

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