European Economy

Multi-Speed Inflation Poses an ECB Dilemma

Prices are starting to rise, but at very different rates for different euro members.

Cheap. Maybe too cheap.

Photographer: Alessia Pierdomenico/Bloomberg

The European Central Bank has spent the last few years battling the threat of deflation with a combination of negative interest rates and a bond-buying splurge. There's now enough evidence to suggest ECB President Mario Draghi should at last acknowledge that inflation has returned. But even if he does, the fissures underlying the euro zone economy will prevent the central bank from reacting in the usual way.

QuickTake Europe's QE Quandary

The two-pronged alteration to quantitative easing introduced by the ECB in December was designed to pacify the bank's monetary hawks (by cutting the monthly amount of bond purchases) while reassuring its doves (by extending the length of the program). But as the headline inflation figures improve and the hawkish calls for tapering QE grow, the euro zone's multi-speed economy will be a barrier to policy normalization.

Draghi says he's not convinced that the current rebound in prices merits a response, given its reliance on rallying energy prices and so-called base effects, hangovers from earlier weakness. But after declining in the year to mid-2016, his preferred measure of inflation expectations -- the five-year, five-year forward inflation swap rate -- has been rising steadily for the past six months. Its current level of about 1.8 percent is its highest since the middle of 2015:

Heading in the Right Direction (I)

Mario Draghi's preferred measure of inflation expectations -- the five-year, five-year forward inflation swap rate

Source: Bloomberg

Other measures also suggest there's a convincing change in the inflation outlook. Ed Hyman, chairman of investment firm Evercore ISI, says the upturn in what companies can charge for their goods in the euro zone provides confirmation that inflation really is heading higher. The IHS Markit PMI survey of the manufacturing industry output prices has climbed to a five-year high in recent months, suggests companies finally have "pricing power," he told Bloomberg Television last week:

Heading in the Right Direction (II)

Index of manufacturing output prices in the euro zone

Source: IHS Markit via Bloomberg

(Note: a value above 50 signals expansion)

The consensus forecast of economists polled by Bloomberg News is that annual euro zone inflation will be between 1.3 percent and 1.5 percent in the coming five quarters. While still below the central bank's 2 percent target, that's high enough to suggest deflation is no longer a threat to the euro zone. But that doesn't mean the ECB's struggle is over.

At his press conference last week, Draghi outlined four characteristics inflation would have to display before the ECB could consider claiming to have met its target:

We define our objective first of all in the medium term, over a medium-term horizon. That's the relevant policy horizon. Second, it has to be a durable convergence, so it cannot be transient. Third, it has to be self-sustained. In other words, it has to stay there even when the extraordinary monetary policy support that we are providing today will not be there. Fourth, it has to be defined for the whole of the euro zone.

It's that final test that will prove difficult, in turn making it harder for the central bank to begin normalizing policy by switching off the economic life-support of QE.

Consumer prices in Germany climbed by 1.7 percent in December; the Bundesbank said on Monday that inflation could reach "a good 2 percent" in January after the economy "clearly gained pace" in the final three months of 2016.

In Italy, however, prices eked out just a 0.5 percent increase in the final month of last year. And looking ahead to what economists are anticipating for those two economies in the coming quarters, the gap remains wide enough to pose a policy dilemma for the central bank:

Mind the Gap

Outlook for annual inflation rates

Source: Bloomberg

Those differing inflation rates are problematic not just for policy makers trying to set monetary policy, but also because of what they say about the underlying economies. Germany's economy probably grew by 1.7 percent in the fourth quarter of last year, according to the consensus view of economists; Italy added just 1 percent, and that differential is expected to persist this year with Italy never beating 1 percent while Germany grows by 1.4 percent or better each quarter. Italy's unemployment rate of 11.9 percent is almost twice that of Germany; it has a budget deficit of 3.5 percent, compared with Germany's 0.7 percent surplus.

As my colleague Leonid Bershidsky has argued, accelerating inflation combined with negative interest rates is a deadly combination in a German election year, given that nation's propensity for saving. That explains the growing calls from Germany for the ECB to begin normalizing monetary policy.

But until there's a catch-up in consumer price increases for the likes of Italy -- and Slovakia, Greece, Ireland and Cyprus, which have inflation rates of 0.2 percent, 0.02 percent, zero and minus 0.25 percent, respectively -- the ECB will struggle to taper quantitative easing. The headline figures will suggest action is needed; but what lies beneath is likely to stay Draghi's hand, no matter how loudly Germany objects.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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