If inflation comes knocking on your door, don’t let him in, because he will always overstay his welcome.
Over the past 40 years, the Western world has forgotten this lesson. Since the early 1980s, we have for the most part been blessed with low inflation rates. Price stability was so widespread that economists began talking about the post-stagflation era as the ‘great moderation.’
For good reasons, those speculations came to an abrupt end a bit over two years ago. Governments, desperate to save their economies from the pandemic-driven shutdowns they had themselves imposed, resorted to unprecedented monetary expansionism. The inevitable consequence: the highest inflation in four decades.
There is no doubt that the long ‘great moderation’ period made politicians, but also economists, forget the relation between money printing and inflation. Another piece of knowledge lost in the mists of time is that of just how persistent inflation can be. Even though inflation is down today compared to a year ago, it remains elevated both in Europe and in America—and now we are seeing some evidence that it may be on the rise again.
Both the Federal Reserve and the European Central Bank have tightened their monetary policies in an effort to bring down inflation. They have both been successful, but not as much as they would like to be. Neither the U.S. economy nor the euro zone has returned to the 2% inflation target that both central banks hold up as their long-term goals. It takes time to get there, but what happens if inflation rebounds? How will the two central banks respond?
A quick look at euro-zone inflation numbers does not suggest that inflation is coming back. According to the latest inflation flash estimate from Eurostat, in September, the euro zone’s annual price increases were down to 4.3%. This is less than half of the 9.9% from September last year and a confidence-inspiring decline from the 5.2% rate recorded in August.
Generally speaking, this estimate brings good news to an otherwise troubled European economy. With 14 of the 20 euro zone member states having lower inflation in September than in August, the common currency area is moving in the right direction. The pace is slow, however, and the trend is not entirely convincing. Most of the 7 countries where the rate is above 5%, show problems with getting inflation down further:
- Irish inflation was at 5.4% in May, then fell a bit below the 5% mark, only to return above 5% in September;
- In France, inflation dipped to 5.3% in June and 5.1% in July, then bumped up to 5.7% in August and 5.6% in September;
- With a rate of 5.5%, Italy finally got below 6% in August, only to see a bounce back up to 5.7% in September;
- Slovenia is moving squarely in the wrong direction: 6.6% in June was followed by 5.7% in July, then inflation rose to 6.1% in August and 7.1% in September.
Slovakia tops the euro zone inflation league at 8.9%, which is down from 9.6% in August and double digits in the several months prior to that. Croatia, which has the second-highest euro-zone inflation rate, is experiencing less of a decline than Slovenia is; its 8.9% in April was followed by 8-8.4% in the following months until the rate fell to 7.3% in September.
There is no doubt that inflation in the euro zone has become a stubborn houseguest. Figure 1 shows the rate for the 20 current members of the currency union, all the way back to 2001. For two years now, the euro zone has been plagued by record-high inflation:
Figure 1
Again, the aforementioned flash estimate brought good news, but at least to some degree, it remains only skin deep. The signs of persistence in inflation are a bit worrisome, in part because there is very little progress in Europe in reducing unemployment. If inflation refuses to come down much further, Europe will have a stagflation problem on its hands.
While the risk for stagflation is not imminent, it is at least as likely as a traditional recession where unemployment rises but inflation falls. One reason to worry about stagflation is that, once inflation conquers an economy, it easily gets entrenched. As demonstrated by the OECD database on inflation, the period of rapid price hikes in the 1970s and 1980s was agonizingly drawn out:
- Britain—double-digit inflation in 1974-1981, except for 8.3% in 1978;
- Denmark—inflation topped 9% in 1973-1982; in three of those years it topped 11%, with 15.3% as its record;
- Finland—in 1973 inflation reached 10.75% and remained above 10% through 1977; after two years just below 8%, it returned to double digits for two more years;
- France—inflation was above 9% in 1973-1984, with three years above 13%;
- Greece—double-digit inflation for more than two decades, 1973-1994, with 7 years above 20%;
- Italy—more than 10% inflation in 1973-1984; the top rate was 21.1% in 1980;
- Portugal—inflation above 10% in 1971-1991, with the exception of 9.6% in 1987;
- Spain—more than 11% inflation in 1973-1984; top rate 24.5% in 1977;
- Sweden—exceeded 9% in 1973-1981, with the exception of 1979.
In other words, the lucky countries in Europe were the ones who got away with less than ten years of high inflation. That is not an encouraging lesson from the past, but it is important to point out that we currently have no indications that our recent episode of high inflation will drag on for a full decade.
The challenge for the ECB is, of course, to have to deal with stagflation. If unemployment creeps upward, the ECB could be pressured to shift to monetary accommodation: lower interest rates, increase liquidity in the cheap-credit market, and facilitate deficit spending by governments.
The problem with such a policy shift is, of course, that money printing is by far the safest way to send prices skyrocketing. Fortunately, at least for the time being, there is no real risk for such a policy shift. The ECB president, Christine Lagarde, and chief economist Philip Lane are both clear on one point: a swing from the ECB’s current path of tighter money supply to any kind of monetary expansion—even a modest one—is highly unlikely.
At the same time, neither Lagarde nor Lane offers any comment on the potential for stagflation in the euro zone. Furthermore, monetary policy is fast-paced by the very nature of money; things can change quickly. I am convinced that behind the scenes, ECB economists are monitoring the stagflation threat, and policymakers at the bank are preparing to respond to it.
For the time being, the ECB will likely refrain from further interest rate increases. This would put them well in line with the Federal Reserve, whose policies the ECB adjusts to with admirable precision.
The close link between American and European monetary policy exhibits itself in a remarkable correlation between their respective interest rates. Figure 2 reports the yield in the secondary (open) market for U.S. government debt (red) and the same debt in the euro zone (blue). These rates are for ten-year treasury notes, the yields on which are conventionally considered the ‘benchmark’ for government debt:
Figure 2
Even though Figure 3 does not reveal anything about the cause-and-effect nature of the relationship between American and European government debt yields, the Federal Reserve has proven by action—especially since starting to raise interest rates—that it is the policy leader. This means, in turn, that the variables that guide the Fed in its policy decisions also exercise meaningful influence over euro-zone monetary policy.
As a result of the trans-Atlantic link, the variables that guide U.S. monetary policy also become governing variables for European monetary policy. This is natural, given how easily large, global investors can move money between the two economies (and elsewhere, of course).
At the same time, the close monetary coordination between the Fed and the ECB can also become a problem for the latter. If the European economy does not slide into stagflation, but instead goes into a normal recession with low inflation and high unemployment, there is a good chance that the euro zone will significantly deviate from the U.S. economy. As a result, the ECB could be forced to conduct a different monetary policy from that of the Federal Reserve.
This scenario is a bit less likely than that of stagflation, but it is far from inconceivable. While European inflation is stubborn, it can still continue downward at a slow pace. By contrast, U.S. inflation is beginning to show signs of being stuck at 1.5-2 percentage points above the Fed’s long-term target of 2%. In June, inflation in the U.S. economy fell to 2.97%, the first month below 4% since April 2021. After that, it crept upward again, reaching 3.18% in July, 3.67% in August, and 3.7% in September.
These are slow and modest upticks, and their cause is not monetary policy. Instead, this is an expectable rebound in consumer prices echoing movements in U.S. producer prices. Although the producer-price index, PPI, fluctuates with a much higher amplitude than consumer prices (measured by CPI), the latter correlates closely with the former. As Figure 3a below explains, the most recent spike in consumer-price inflation (blue) was preceded by a sharp rise in producer-price inflation (red):
Figure 3a
If we compare the turn upward in PPI inflation (technically a decline in PPI deflation) that is currently taking place, to previous turn-around events in the U.S. economy, we have good reasons to believe that consumer-price inflation will remain elevated. In fact, looking toward the end of this year and into the first quarter of 2024, there is a greater chance of higher inflation than lower.
This leaves us with the quite possible scenario where U.S. inflation slowly ticks upward toward 5% over the next six months, while the euro zone ticks down under 3%.
Monetary inflation is rapid, volatile, and unlimited in how high it can go. By contrast, inflation of this kind, which is not caused by monetary expansion but by regular swings in product markets, is confined in both the level and pace of change. This means that any policy responses to it will be less dramatic than when monetary inflation is at hand.
With less drama in policymaking, a divergence of inflation rates between Europe and America would afford the ECB some time to respond independently of what the Fed does. When they act, they would have few options:
- If the U.S. inflation rate ticks up because the economy remains strong with high GDP growth, and likewise, euro-zone GDP is weak or even in decline, then
- The Federal Reserve will keep its interest rate high while the ECB is forced to cut its rates.
This will lead to a divergence of interest rates in line with the difference in inflation and GDP growth.
The problem for the ECB in this situation would be that its policy would deliberately weaken the euro. This, in turn, will cause inflation to return through import prices, including but not limited to energy. Investors will now expect the ECB to return to its inflation-fighting policy; if they don’t, the markets for euro-denominated government debt will weaken and cause a market-driven rise in interest rates. This, in turn, puts the ECB in the back seat; they are forced to follow the market, not lead it, as a central bank should.
Europe has a recession ahead of itself. The question is whether or not rising unemployment will come with higher or lower inflation rates—and monetary conservatism or monetary expansion.
