The ECB’s job is very hard right now.
Officially its sole job is to guard against inflation. But in the 20 years since the formation of the euro, there’s been approximately no inflation. The bank could have been forgiven for being complacent. It has, for instance, been trying to raise rather than lower inflation for the last nine years or so. Despite having the ability to print unlimited quantities of money, it has failed. Likewise, the Bank of Japan has been trying and failing to increase inflation for ten years.
Now all of a sudden, inflation is here. Having averaged just 1.7 per cent since the formation of the euro in 2002, and never gotten higher than 4.1 per cent, inflation last month reached 7.4 per cent.
This is not how it was meant to happen. Inflation was meant to gradually tick up to the two per cent target, and maybe exceed it slightly. Central bankers might have expected to subdue it with a gentle tap of the brakes.
But looking at 7.4 per cent inflation in the eurozone, a gentle tap might not do it. To get inflation back under control, the ECB might have to tighten so much that we end up with a recession.
This is the 1980 scenario: when the Fed decided to get tough on inflation by raising rates sharply. It succeeded in killing off inflation but it crashed the economy in the process.
These are the stakes. Inflation can be very bad. When it's allowed to get out of control it reduces spending power more than wages are increased. And the longer it beds in, the harder it is to eradicate since it gets built into wage expectations and so on. But tightening too much can cause a recession.
So why doesn't the ECB act firmly and quickly, and nip inflation in the bud?
Too hot or cold
If the European economy is an engine, inflation is an engine overheating. It's the machine going past the limit of its capabilities.
The European Central Bank can lower the temperature of the engine (reduce the total amount of spending in the economy) by taking its foot off the accelerator (raising interest rates, aka reducing the size of its balance sheet).
There's an additional detail: not all prices come from within the European economy. The price and quantity of imports come from outside the European economy, and are frankly a bad fit for the whole engine metaphor.
So central bankers, whose job is to make sure the engine is running at the right temperature, need to distinguish the inflation that comes from within the economy from the inflation coming from outside it. Central bankers can only affect inflation that comes from inside the economy.
The danger is that central bankers mistake imported inflation for high domestic inflation, tighten policy, and cause a domestic recession that does nothing to reduce inflation whose true source is external.
So here we are in May 2022. Inflation is very high. But the Ukraine war has caused food and energy prices to go up. Food and energy prices are set internationally. And, for example, 58 per cent of Europe's energy is imported.
If what we're seeing is a consequence of the Ukraine war, the correct response from the ECB is to hold tight. Firstly, because the ECB can't control imported energy prices. And secondly, because energy prices have stepped up. They're a once-off, inflation-wise. Not a source of consistent inflation, year-in-year-out.
How would we know if inflation is imported or domestic? One way of assessing whether the engine is overheating is to look at nominal GDP. Nominal GDP is the closest thing we have to a combined temperature gauge for the economy. It shows all spending in the economy added together, unadjusted for inflation. So it gives a sense of both prices and output, in one number.
Since inflation has been subdued for the last 10 years, the trend growth of nominal GDP shows how much spending the economy can handle without inflation. In the US, it's been 3.7 per cent; in the eurozone, it's been 2.9 per cent.
If nominal GDP growth is above trend, it's a sign the economy is overheating; likewise, if it's below trend, it's a sign the economy is running too cold and needs to catch up.
The following chart shows nominal GDP for the eurozone; the dotted line is the 2010-2020 trend. What the chart is saying is that the eurozone economy doesn't look like it's yet overheated.
The situation looks different in the US. Like Europe, the US has high inflation — 8.5 per cent in March. The chart shows that the US economy is running hotter than the eurozone. And the US doesn't have Europe's excuse that high inflation is imported from abroad, since it doesn't import as much energy.
High inflation, high rates
This isn't just a matter for Philip Lane and the ECB people. Anyone with debt wants to know what direction interest rates are headed.
The Fisher Equation says interest rates are equal to inflation-adjusted rates plus the expected rate of inflation. In other words, expected future inflation is the key determinant of interest rates. This relationship, between expected inflation and interest rates, closely fits with the evidence since the turn of the century.
What does the Fisher Equation say today? The expected inflation rate is known: securities linked to euro-area inflation over the next ten years are trading at a 3.1 per cent yield. That means the market is expecting the inflation rate to average 3.1 per cent over that period.
(3.1 per cent is the number for the eurozone as a whole, so in theory, Ireland's might differ. But for five or ten years, you'd expect the numbers to be about the same.)
Does that mean you should rush out and fix your mortgage at anything less than 3.1 per cent? Not quite. The most recent reading for eurozone inflation, from March, was 7.4 per cent (6.9 per cent in Ireland). As we've seen, some of that is temporary. It's coming from a) the last of the pandemic-related supply issues, b) the spike in food prices as a result of the Ukraine invasion, and c) the spike in energy prices as a result of Ukraine. These price spikes would be expected to wash out of the inflation numbers in the next year or so. So when the market is forecasting 3.1 per cent inflation over 10 years, that includes a 7.4 per cent number this year and an elevated number in 2023 too. So maybe inflation settles at around 2.5 per cent from 2024 on out.
If the Fisher Equation holds up, that implies interest rates of 2.5 per cent or more. These will take some getting used to, particularly for anyone lucky enough to be on trackers for the last ten years.