The ECB should not tighten too fast
Inflation in the Euro zone is high, but that's no reason to change course
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European inflation has recently surged to 8.1% year-over-year, roughly matching the rate in the United States. Economist Tyler Cowen recently asked “which views do we at least think about revising” in light of this fact? This post is my best attempt at answering this question.
Is it supply shocks all the way down?
Both Europe and the U.S. were hit with a whopper of an adverse supply shock in the form of COVID-19. Between the direct loss of production during the pandemic and the slowness by which production could ramp up again (particularly with computer chips), we would expect inflation to rise under any reasonable policy regime. Of course, the Russian invasion of Ukraine sending oil, natural gas and food prices soaring constitutes a second major supply shock, and one that definitely hits Europe far harder than the U.S. For example, natural gas prices at the start of May were $37/mmbtu in Europe, compared to $8.42 in the United States.
The food and oil supply shock is not the entire explanation, but it is a major part. Core inflation, which strips out those two categories, rose above expectations to 3.8 percent in the most recent print. And of course core inflation in the Eurozone started rising in the fall well before the Ukraine invasion (though this fact is perfectly consistent with there being two overlapping adverse supply shocks, one being post-Covid adjustments and the second being the war). But in the US, core inflation is 6.1 percent. The greater wedge between headline (which includes food and energy) and core (which does not) in Europe suggests the war is a major difference between the two inflation pictures.
Supply chain difficulties in the fall and the war in the spring can’t explain why service prices are rising 3.5% year-over-year, however. Fiscal policy could play a role–Europe had a large response, though far smaller than the response in the US. Those facts are consistent with a high European core inflation rate that remains substantially lower than their American counterpart’s rate.
I’m generally skeptical of the fiscal-policy-to-inflation pipeline, largely because central banks can counteract over-eager stimulus if they so choose. But for the time being, let’s consider it a candidate. The ECB still should eschew calls for aggressive tightening.
Nominal spending in Europe is still below-trend
The biggest difference between the European and American inflation situations is nominal spending (a.k.a. total spending in the economy, a.k.a. real GDP + inflation). As we’ve discussed before on this blog, central banks have near complete control over nominal spending. And targeting consistent trend growth in nominal spending is an ideal form of monetary policy, since if we assume a modest level of wage stickiness, maintaining the same (or slightly growing) level of nominal spending allows firms to retain workers at the same nominal wage even when a recession causes a drop in real output.
Note: For the trend lines, I used 5% for US and 4% for Euro zone to reflect their different pre-pandemic trend growth rates.
The above chart illustrates just how different the European and American situations really are. In the US, the Fed (along with Congress) acted highly aggressively and quickly got NGDP back to trend. If anything, they’ve now overshot by about $100 billion and need to quickly course-correct. In contrast, in Europe they still have a gap of nearly $1 trillion USD. Of course, central banks don’t target the current NGDP gap but instead expectations of future gaps. But in the absence of a liquid NGDP futures market, it seems reasonable to conclude that under current policy the Euro zone is far from “overheating”. That data is consistent with the lagging nominal wage growth in Europe.
So… what does this mean?
It may seem callous, but sometimes inflation is necessary. When a country (or bloc of countries) faces a large-scale adverse supply shock, your economy can either adapt through inflation or layoffs. There’s no two ways around it. It’s certainly painful for Europeans to face high cost-of-living hikes with sluggish wage gains. But when the supply shock fades, inflation will also come down too. Accelerating the rate hike schedule in Europe, as some commentators have suggested, would only widen the NGDP gap and likely be inappropriate for the current situation.
Before signing off, it’s worth addressing that the ECB only has a single-mandate to promote price stability. The Federal Reserve, in contrast, has a dual mandate to promote full employment and price stability. In the European context, then, rate hikes to reduce inflation at the cost of higher unemployment is more justifiable. But it’s a silly mandate and rate hikes will likely cause more harm than good. ECB leadership should still tread carefully.