Of the two macroeconomic illnesses — inflation and unemployment — inflation is by far the less popular.
The pain of unemployment is felt unevenly. During a recession, the median person does just fine. They still have a job, and their cost of living even falls slightly. The unemployed are miserable, but relatively few in number.
The pain caused by inflation, by contrast, is less acute but more evenly spread. It hits everyone. You are reminded of it all the time — that anxious sense that your living standards are slipping away, month by month.
In Ireland, the annualised inflation rate in May was 7.8 per cent. That’s the highest level since the oil shocks in the early 1980s. Across the eurozone as a whole, inflation has never been higher.
Nothing damages the approval ratings of US presidents as much as inflation. According to Harbridge, Krosnick and Wooldridge (2016), every 10 per cent rise in the cost of petrol lowered the US president’s approval ratings by 0.72 per cent. Increases in the price of food and drink lowered the president’s approval rating more than 10 times as much as increases in the unemployment rate.
Why has this happened?
It’s the ECB’s job to control inflation. Why have they let it get out of hand? Why are they not raising interest rates?
As I wrote in May, the answer is that the ECB has the power to control the most common forms of inflation, but not all of them.
The most common form of inflation is when an economy is running too hot — the classic “too much money chasing too few goods” scenario. Interest rate rises are a good cure for a too-hot economy.
The less common form of inflation is when inflation is imported, in for example higher energy prices. The eurozone is an economy that, unlike the US, is heavily reliant on imported energy, and is vulnerable to imported inflation. Interest rate rises are useless against imported inflation.
So the people at the top of the ECB have to weigh up three questions simultaneously. The first is, is unemployment too high? The second is, is inflation too high? And the third is, is the inflation coming from inside the eurozone or outside of it?
Clearly, at least some of the inflation we’re experiencing is coming from outside the eurozone. Having averaged about $55 in the years leading up to the pandemic, a barrel of oil now costs $100. European natural gas had traded in a range of €20-25 per megawatt hour; today it trades at €176.
How would an ECB official know how much inflation is generated domestically, and how much is imported? Nominal GDP (NGDP) is helpful here. Nominal GDP is a good temperature gauge for the economy. It simply shows all spending, added together.
In a healthy economy, NGDP grows by a couple of per cent per year — the trend in the eurozone for the last decade has been 2.9 per cent growth per year. As the following chart shows, by the end of Q1 2022, the eurozone economy hadn’t yet overshot its trend line. So, at that point in time at least, the economy wasn’t overheating. So the inflation Europe was experiencing was coming from higher energy prices and other imports.
But what’s also clear is that by March, euro zone NGDP was closing in on that trend line, which is the speed limit of the eurozone economy. Extra spending above that limit increases inflation. It is not desirable. Extrapolating the NGDP trend forward to July, it looks likely that the eurozone is at its limit by now.
Other straws in the wind would seem to support the case that the eurozone economy is at capacity. Unemployment is running at 6.8 per cent, which is extremely low by eurozone standards. The following chart shows the unemployment rate and the eurozone’s average unemployment rate since 2005.
By the standards of the US, 6.8 per cent would not be considered full employment. But maybe in Europe, things are different, and maybe it is.
The upshot of all this is that the ECB has held off as long as possible. There are no more workers to be brought back into the economy. No more free lunches. Now, it’s going to have to get tough on inflation.
We’re looking at a series of rate rises. The plan is for one quarter point interest rate rise on the 21 of July, followed by bigger ones, until inflation is licked.
There are good reasons to think the ECB will beat inflation. The first is theoretical: a determined central bank should always be able to control inflation. As Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon”.
The second is that we know the ECB is determined. Central banks in general tend to hate inflation, and the ECB hates it most of all. For the last decade, the doves on the ECB have had to fight tooth to stop the hawks from raising rates. If ECB doves like Philip Lane and Fabio Panetta relent, the rest of the institution will be only too willing to tighten.
The third reason is that the market expects it to. The five-year five-forward rate shows the market’s expectation of average inflation rates for the next five years. Today, the market’s expectation is for inflation to average 1.9 per cent. That’s down from an expectation of 2.45 per cent in April.
So we’ve run out of road; from here on out the ECB can’t support the economy any longer. Expect tighter monetary policy, perhaps a slowdown in the economy, perhaps a recession. The stock market recognises this. European stocks are off by a fifth since the beginning of the year.
The disappointing thing is that the economy never really hit its straps. The boom is over before it even started. That’s the cost of the war to Europe — higher prices and stagnant incomes for a couple of years. According to the ECB’s estimates, it’s going to reduce real incomes by about 1.3 per cent per year.
The inflation we’re experiencing at the moment isn’t going to last. The ECB will see to that. But the slowdown that will replace it won’t be much better.