From Frankfurt with love
It’s done. Before the summer, Mario Draghi has set out the European Central Bank (ECB) monetary policy anchor points for the next few months. In line with our scenario, he announced that the ECB would taper its asset purchases from €30 billion to €15 billion a month from October, continuing to December 2018. He repeated that the proceeds from maturing securities would continue to be reinvested for a long time to come and, in any event, as long as is necessary to ensure favourable liquidity conditions. Lastly, he said interest rates would be maintained at current levels until summer 2019 at the earliest and, in any case, as long as is necessary to ensure inflation converges towards the ECB’s target.
The ECB has taken note of the slowdown in the eurozone economy in the first quarter of 2018, but has not changed its forecasts for the coming quarters. However, it has downgraded 2018 growth (from 2.4% to 2.1%). It still considers the upside and downside risks to this scenario to be balanced, but is attaching growing importance to rising uncertainty over the macroeconomic and geopolitical environment, and to increased market volatility. Meanwhile, it has adjusted its inflation forecasts upwards for 2018 and 2019 (from 1.4% to 1.7%) but not for the longer term (1.7% in 2020). It has maintained its core inflation forecast (i.e. excluding volatile components) for 2018 (1.1%) but raised it for 2019 (to 1.6%), thus signalling that inflation will only converge towards the 2% target in 2020 (at 1.9%). Even if inflation, as we anticipate, fluctuates between 1.9% and 2% over the next six months due to the rising price of oil, that will not translate into an equally rapid or permanent rise in core inflation. A number of structural factors will continue to moderate expected inflation out to 2020. First is the labour market slack, which refers to people who are not in work but want to work and are not counted as unemployed – i.e. those in involuntary partial employment and the “discouraged unemployed” who are no longer looking for work. In the eurozone, this additional excess labour market capacity adds ten percentage points to the official unemployment rate and constitutes a supply of labour that can be tapped into before demand for workers translates into wage pressure. Then there are the surveys, which are beginning to indicate labour shortages in some eurozone countries. These should be seen as frictional phenomena, not as signs that supply is genuinely becoming constrained (with the possible exception of Germany, which is further along in the cycle). And to those who might have thought this shortage of labour so early in the economic cycle reflected a higher equilibrium unemployment rate resulting from a crisis that had permanently driven workers out of the labour market, the ECB has answered that this was not the case. Proof that the labour market slack is cyclical and not structural is seen in the fact that it is declining with the unemployment rate. We might add that, while the Phillips curve (which represents the inverse relationship between the unemployment rate and changes in wages) is not dead, it has, at the very least, been weakened by a structural change in wage formation mechanisms resulting from globalisation and labour market reform.
So the ECB’s strategy of patience, prudence and perseverance is not going to change. Its actions will continue to be guided by three principles: seeing inflation converge towards its target, confidence that such convergence is highly likely, and the resilience of this convergence – i.e. its self-sustaining nature independent of any highly accommodative monetary policy.
Although the ECB has said it is confident that uncertainty around this convergence has diminished, many questions remain around the key variables that determine the optimum monetary policy stance. What is the equilibrium interest rate level around which base rates can be varied depending on cyclical growth and inflation conditions? What is the equilibrium unemployment rate? What is the slope of the Phillips curve – i.e. the relationship between rising wages and prices and declining unemployment? How does unconventional monetary policy affect growth and inflation? Uncertainty around these issues will serve as justification for a gradual, pragmatic and cautious approach. It could also serve to justify a “symmetric” interpretation of the inflation target by the ECB, allowing inflation to overshoot the target to take the time to repair all the structural damage to the labour market caused by the crisis, as well as to enable inflation expectations to anchor themselves around an inflation rate of at least 2%. By confirming that quantitative easing is part of its “normal” toolbox, the ECB is indicating that the equilibrium interest rate is now lower than in the past – which, by increasing the frequency of negative interest rate episodes, may justify a preference (or tolerance) for higher inflation.
In thus anticipating and neutralising all the pressure that could result from the temporary rise in inflation over the next few months, Draghi is calmly preparing the eurozone for a peaceful summer holiday. While it waits for countries to agree on common instruments to better share the role of macroeconomic stabilisation between the monetary authority and budgetary authorities, the ECB is sending out a signal that it is still there to ensure the integrity of the eurozone. But the time has come to address the issue of how to improve coordination between monetary policy and fiscal policy to that the former can more effectively achieve its goal of price stabilisation.
Paola Monperrus-Veroni, Group Economic Research