Why is euro-area inflation so low?

by on August 1, 2014 at 1:59 am in Economics, Law, Political Science, Uncategorized | Permalink

Sober Look has the numbers, for instance:

The area’s CPI is now below 0.5% on a year-over-year basis. Yesterday we saw German CPI hit new lows (see chart) and Italy’s inflation rate is now hovering just above zero.

What is the most economical model here?  The ECB invested in building up a lot of credibility in some areas, such as price level stability, but that means less credibility when it comes to pushing higher inflation.  So to get two percent inflation, perhaps the ECB has to genuinely and truly seek four percent inflation, because a big chunk of the market won’t believe they really want four percent.  Four will get them to two.

The ECB in fact may be wishing for two percent price inflation and getting…less than that.  Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking.  The ECB and the citizenry can get stuck in a self-fulfilling prophecies equilibrium, yet without requiring a standard liquidity trap.

I don’t by the way think of this as a time consistency problem.  The ECB doesn’t want to be in a position where it is genuinely shooting for four percent inflation, even if that means it will end up imposing only two percent on the Germans.  They are still caught with their proverbial pants down and their internal culture of inflation love would be seen as unacceptable and illegal too.  Yes, the ECB is selfish, and law-abiding as well, as its charter mandates price stability as the goal.

And you know what?  When “selfish” and “law-abiding” point in the same direction, that is very often what you will get.

CMA August 1, 2014 at 2:19 am

Bringing into effect more effective transmission mechanisms for monetary policy should be the best way to increase ECB credibility and allow it to hit higher inflation if it wishes.

JC August 1, 2014 at 3:27 am

Low economic growth and high competition lead to aggressive pricing policies and prices tend to go down.

Competition will eventually destroy even more companies and until a new balance is found, prices will keep falling.

At least low inflation should keep EU exports attractive in a context of overvalued currency.

Daniel August 1, 2014 at 7:58 am

Except it’s not price inflation/deflation that matters, but wage inflation/deflation.

overvalued currency

So you’re saying the ECB should just print some more money ? 100% in agreement.

genauer August 1, 2014 at 2:52 am

The European inflation index includes food and energy, in contrast to the Fed’s PCE ex food and energy.

Food and energy are cheaper this year, good, but it will not last.

The countries with wages risen too high, mainly at the periphery, are in moderation,

but now the German wage increases will kick in:

8.5 Euro / hr = 11$ minimum wage

The largests private union in the world, the German metal worker union, got last year a 6% raise, and another 4% this year, that will get some inflation going

and the target is, that mid term (3-5 years) inflation is LOWER, but close to 2%

Integral we are very close to 2% over the last 12 years, sooo, move on, nothing to be seen here : – )

andrew' August 1, 2014 at 4:21 am

Doesn’t this imply that most Germans could renegotiate their salaries and thus negate real personal effects of inflation?

Daniel August 1, 2014 at 4:30 am

Oh look, if it isn’t our very own German racist.

Quick, tell us how those inferior southerners need to pay for the sin of not being German.

TallDave August 2, 2014 at 12:28 am

Like Texas, Germany can achieve substantial personal income growth without creating inflation.

Spencer August 2, 2014 at 1:14 pm

The BLS reports that the CPI is rising at a 3.3% rate in Houston.

Willitts August 1, 2014 at 3:28 am

I can already guess what SS has to say about this.

And that’s both Scott Sumner and Steve Sailer. :)

The Devil's Dictionary August 1, 2014 at 3:46 am

There’s credit deflation in the eurozone, first of all.
http://www.devilsdictionaries.com/blog/deflation-in-eurozone

You can’t beat credit deflation just by merely cutting rates. Not even QE is meaningful. It’s just the lact of debtors with good rating/scoring.

Everything else is unimportant.

andrew' August 1, 2014 at 4:14 am

What you need is a way to transfer ownership without disrupting going concern revenues.

prior_approval August 1, 2014 at 3:48 am

‘So to get two percent inflation, perhaps the ECB has to genuinely and truly seek four percent inflation, because a big chunk of the market won’t believe they really want four percent. Four will get them to two.’

Man, this would be hilarious to translate into German, and read out at the EZB’s Frankfurt Eurotower. The laughter would not be at any sense of this being satirical, however. Even if this passage is watered down later by saying the EZB doesn’t want to be credible in creating even 2% inflation, much less 4%

‘The ECB in fact may be wishing for two percent price inflation and getting…less than that. Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking.’

Not quite as amusing, but completely alien to how the former Bundesbank, with its broad support among German voters, ever viewed things. Nobody in Germany feels a need to credibly cause inflation at a central bank level – ever.

‘They are still caught with their proverbial pants down and their internal culture of inflation love would be seen as unacceptable and illegal too.’

Actually, no – there is quite a bit of concern in the German press (and when the Bild makes it a front page issue, as in the last few days, it become a broad issue) about lower rates of interest on investment income. But Germans feel growth is distinct from inflation. Probably because they don’t need to read only English language economic history texts.

Millian August 1, 2014 at 5:15 am

Why not start your own blog? Or perhaps pay rent.

Daniel August 1, 2014 at 4:33 am

The ECB in fact may be wishing for two percent price inflation and getting…less than that.

What is this bullshit ?

The inflation the Eurozone is getting is the inflation the ECB wants. And the inflation the ECB wants is the inflation the Germans want. Namely, (almost) none at all.

If that means continent-wide recession, so be it.

Those lazy Southern Europeans deserve it, anyway.

David Wright August 1, 2014 at 5:09 am

Those “lazy Southern Europeans” want it, too, or at least they wanted it in the past. They signed up for German monetary policy precisely in order to send creditors the signal that they would not devalue even in the face of recession. To make this clear, the EZB charter specifically gives it a single mandate (low inflation) in contrast to the fed’s dual mandate. Signing up for that bought them a decade of low interest rates.

Daniel August 1, 2014 at 7:27 am

Low inflation is very good.

Deflation is very bad.

In order for the Germans to have low inflation, the Eurozone periphery must endure deflation.

Are you starting to see the problem here ?

Oakchair August 1, 2014 at 2:17 pm

There are high debt loads meaning low inflation is bad. High inflation erodes debt which would then eliminate deleveraging and result in more people/corperations being able to invest/consume and contribute to the economy.

Tom August 1, 2014 at 4:34 am

All this time and so many people still don’t get it. Inflation is caused by increases in nominal spending faster than the pace of real growth. Central banks don’t spend, they lend. If a central banks wants to boost inflation, it needs to either:
1) lend to commercial banks that wish they could borrow cheaper and more in order to lend to clients who wish they could borrow cheaper and spend more
2) lend directly to private real sector businesses or people who wish they could borrow cheaper and spend more
3) lend to a government that wishes it could borrow cheaper and spend more

3 is limited by EU pressure to meet deficit and debt targets (for good reasons, at least in the states that are most eager to spend)
2 is taboo (for good reasons)
1 is limited by short rates already being at zero

Announcing a 4%, 6%, 8%, whatever % target is not going to make one iota of difference unless limitation 2 or 3 is lifted. Markets respond to central bank targets when they’re tied to credible supporting policies. Witness Japan. The target is 2. QE is flowing thick. The market says meh.

We all know the left wants Germany to boost public spending. Is that what you’re suggesting? Or what?

Daniel August 1, 2014 at 8:00 am

If a central banks wants to boost inflation, it needs to either

Except there are other instruments by which monetary policy can be conducted. Direct intervention in the FX markets (like the Swiss succesfully did a few years ago).

So your “analysis” (I’m being generous here) is bunk.

8 August 1, 2014 at 4:42 am

Agree with above posters about credit deflation, but also TFR.

dearieme August 1, 2014 at 5:09 am

If the ECB is law-abiding it’s the only bloody euro institution that is. Lawless and corrupt is par for the course.

Daniel August 1, 2014 at 8:02 am

And yet, for all their law-abiding, they managed to plunge the entire continent into recession. Some law that must be.

Luis Pedro Coelho August 1, 2014 at 5:24 am

This Germany vs PIGS setting has some truth to it, but, to cite another recent post, “countries are a they not an it.”

If you had a referendum on 2% inflation (let alone 4%), do you think the Portuguese and the Spaniards or the Greeks would vote Yes by a huge majority, who would then be outvoted by Germany?

There are large groups of people (and an even larger fraction of voters) in the PIGS who would oppose higher inflation. Some of this is money delusion, surely, but some of it is actually quite correctly selfish behaviour.

In P(ortugal), the constitution has been interpreted to mean that (1) public sector workers may not get a pay cut (or fired) and (2) pensions cannot be cut after retirement. Both of these are nominal rules, of course. A higher inflation target would, in fact, mean that they lose purchasing power (what Tyler would call A Great Reset).

This is basically what happened in the early 1980s (the last time Portugal has an IMF bailout). At the time, inflation was jacked up to double digits and pensioners lost 50% or more of their pension value. Retirees now remember this.

Only France (not one of the PIGS) has shown a consistent preference for different monetary policy (even that is phrased as a “weaker euro”). Inside the eurozone, there is otherwise no coherent opposition to tight money. Unlike in the UK or US, this debate almost does not exist.

ChrisA August 1, 2014 at 5:27 am

Expectations fairy in reverse. Japan is showing that if you really want inflation, even with an economy at zero bound or near to it, you can have inflation. Everyone is expecting (based on recent history well founded expectation) that at the first hint of rising inflation (well before the 2% target is reached) the ECB will stamp it out, likely over reacting. The 2% is seen as a maximum limit therefore not the expected average over time.

What is happening here is that the Germans don’t trust the rest of the EU with even a small amount of inflation. They are treating southern Europe rather like a reformed alcoholic, the smallest drop of inflation will have them back to the bars. It is funny, but all central bankers seem to be Austrians nowadays.

Longer term this may all work and eventually the rest of Europe will become like Germany in terms of wage restrain. But it will be painful getting there.

BC August 1, 2014 at 5:58 am

Nowadays, with inflation-linked bonds (ILBs) markets, there is no excuse for central banks to miss their inflation targets. If they would announce that they will do anything it takes to peg the market implied expected inflation to a target, then they will hit that target. There is no need to overshoot (or undershoot) anything; just a need to target market implied expectations instead of trying to discern trends from recent historical economic data and arguing over whether such trends represent “noise” or are real (no pun intended).

I don’t know when Eurozone ILBs were established, but US TIPS were first introduced in 1997. It’s time for central banks to move on from their pre-1997 mindset. Inflation expectations are now directly observable.

genauer August 1, 2014 at 8:18 am

Just forget that TIPS would predict real inflation in times like this.
Come back to this in 2017 in the US and 2018 in Euroland.

This is a small market, which can easily be manipulated by the Fed via QE, and is governed by fundamental restrictions of annuity and other markets in Europe

http://www.pimco.com/EN/Insights/Pages/The-Mess-That-Is-the-Eurozone-Inflation-Linked-Bond-Market.aspx

Peldrigal August 1, 2014 at 8:33 am

Japan scolded for printing money, how dumb of them, everybody knows that consumption patterns depend on wages and demography, and exports depend on productivity, not on exchange differentials.
Europe scolded for not printing money, how dumb of them, everybody knows that consumption patterns depend on expectations about nominal prices, and exports depend on exchange differentials.
An article with historical series demonstrating how deflation is not correlated to growth or recession.
An article on how Europe should bolster inflation

But it’s ok, I’ve stopped reading anything people across the Pond say about the Euro since the late 90s.

ThomasH August 1, 2014 at 11:11 am

I do not understand the idea of more credibility at preventing inflation going above 2% would mean lack of credibility at preventing inflation from going below 2%. Either ECB knows how to do monetary policy or they don’t. Does anyone think ECB has been trying to get inflation up to 2% and failing? That sounds like believing that the Fed faced a (technical) ZLB on it ability to offset the fall in AD associated with the recession.

genauer August 1, 2014 at 2:24 pm

ThomasH, there is nothing more to understand about it.

The deflation scare is just attempt nr 20 to break the Euro treaties, to destroy the hard currency Euro and to steal from Germany.

It comes from the usual suspects, nothing new, and of course it will not work / happen.

Daniel August 1, 2014 at 2:53 pm

Those damn lazy Southern Europeans, how dare they think the ECB should conduct a monetary policy that doesn’t send them into a recession.

They should be punished for their original sin – not being German. Over and over. Until they repent.

Jason Smith August 1, 2014 at 4:02 pm

EU inflation is low because the information-carrying capacity of a Euro (~ 1/log M) is small relative to the number of Euros around (~ M)**:

http://informationtransfereconomics.blogspot.com/2013/11/secular-stagnation-and-eu.html

This model is predicting near zero inflation and eventual Japanese-style deflation. Of course it might be wrong, but then the idea that the ECB could aim for 4% inflation based on limited credibility in order to achieve 2% inflation with credibility is hard to reconcile with logic. Does the ECB secretly aim for 4%? Because if it gets out that the EU is aiming for 4% in order to produce 2%, people will just realize it’s the old 2% target and they’ll get 0.5% again, right? Or does it tell the EU it’s aiming for 4%, resulting in 2% and everybody figures out that the EU target is 2x% (or x -2 %, or whatever) when they want inflation to be x%, thereby incredibly achieving their a credible target and manufacturing credibility out of thin air?

** The actual metric is that log NGDP/log M is small.

Jason Smith August 1, 2014 at 5:00 pm

Here’s a more detailed response if anyone is interested:

http://informationtransfereconomics.blogspot.com/2014/08/zen-koan-inflation-targeting.html

mulp August 1, 2014 at 4:39 pm

Stocks need to be added to the CPI and then the high inflation rate will cause panic, interest rate hikes, and wage freezes and layoffs.

But at least wages and benefits tied to the CPI will go up and put more money in the pockets of people who do not buy stocks.

As it is, the high inflation in stock prices puts more money in the pockets of those who buy and drive up stock prices by forcing firms to cut wages and hike prices to boost profits to justify the inflated stock prices.

The Fed and ECB could cause inflation in the CPI by directly forcing buying of goods and services, for example by demanding bonds for new infrastructure projects with revenue devoted to servicing the debt. For example, if the central bankers sought out 50 year bonds for projects like replacing the water piping of Baltimore, Chicago, LA, San Francisco, where the existing piping is 75-100 years old so repaying a 2% interest bond over 50 years will repay the debt well before the end of life.

Or buying 50 year bonds to reroute rail lines so they do not conflict with city traffic – almost all rail lines in the US were built cheaply at grade level in mostly rural areas, but because the railroads generated commerce, towns grew up around the rail lines so the rail lines at grade crossing interfere with car traffic, yet the rail lines are the only way to carry bulk cargo, but often can’t carry containers because trucks hauling containers take priority over trains at all the rail crossings. Given rail lines were built a century ago or more, investing in rerouting rail lines to speed rail and road traffic is almost certainly going be still producing benefits a century from now long after the bonds are repaid.

The annual debt service on 50 year 2% bonds would be about $32 million per year per billion dollars of jobs created by a billion dollar infrastructure construction project bond. That would multiple $32 million of current tax revenue for gas taxes or water and sewer bills or property taxes into a billion dollars of jobs created.

TallDave August 2, 2014 at 12:24 am

I suspect the ECB is getting pretty much what the ECB wants. Their monetary policy is more or less appropriate for Germany.

The ECB invested in building up a lot of credibility in some areas, such as price level stability, but that means less credibility when it comes to pushing higher inflation.

I think what you’re really saying here is that people don’t expect the ECB to inflate.

Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking.

There’s a really easy way to fix that — the ECB can decide to raise and hit its targets. They don’t want to.

Darren Johnson August 2, 2014 at 3:41 am

#ScottSumnerProblems

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