A few years ago the news about the euro-zone economy was uniformly bad to the point of tedium. These days it is the humdrum diet of benign data that prompts a yawn. This week figures show that GDP rose by 0.6 percent in the three months to the end of September, an annualized rate of 2.4 percent. The European Commission’s economic-sentiment index rose to its highest level in almost 17 years.
Nonetheless, when the European Central Bank’s governing council gathered on October 26, it decided to keep interest rates unchanged, at close to zero, and to extend its bond-buying program—also known as quantitative easing or QE—for a further nine months.
The central bank said that it would slow the pace of bond purchases each month, to $35 billion as of January. However, Mario Draghi, the bank’s president, declined to set an end-date for QE. A hefty dose of easy money will be necessary, he argued, until inflation durably converges on the ECB’s target of slightly below 2 percent.
It shows few signs of doing so, despite the economy’s strength. Underlying, or core, inflation, which excludes the volatile prices of food and energy, fell from 1.1 percent to 0.9 percent in October, according to data published a few days after the ECB meeting. The euro zone’s miseries of 2010-2012 were unique. In its present, happier state of vigorous activity, low inflation and easy monetary policy, however, it is like many other big economies.
After a decade of interest rates at record lows, those central banks that are inclined to tighten policy naturally attract attention. The Bank of England’s monetary-policy committee raised its benchmark interest rate from 0.25 percent to 0.5 percent on November 2, the first increase since 2007. On the same day the Czech National Bank raised interest rates for the second time this year. The Federal Reserve kept interest rates unchanged this week, having raised them in March and June, but a further increase is expected in December.
In Turkey, perhaps the only big economy that obviously is overheating, the central bank—which has been browbeaten by President Recep Tayyip Erdogan, who believes that high interest rates cause inflation—opted on October 26 to keep interest rates on hold.
In most large economies, however, underlying inflation is below target and monetary policy is being relaxed. On October 25 Brazil’s central bank cut interest rates from 8.25 percent to 7.5 percent. Two days later Russia’s central bank trimmed its main interest rate, to 8.25 percent. This week the Bank of Japan voted to keep rates unchanged and to continue buying assets at a pace of around $700 billion a year.
These economies are gathering strength. It is a puzzle that, in such circumstances, global inflation is stubbornly low.
To figure out why, consider the model that modern central banks use to explain inflation. It has three elements: the price of imports, public expectations and capacity pressures, or “slack,” in the domestic economy.
Start with imported inflation, which is determined by the balance of supply and demand in globally traded goods, such as commodities, as well as shifts in exchange rates. Commodity prices have picked up smartly from their nadir in early 2016. The price of oil, which fell below $30 a barrel then, has risen above $60.
This has put upward pressure on headline inflation: In the euro zone it is 1.4 percent, half a percentage point higher than the core rate. Where inflation is noticeably high, it is generally in countries such as Argentina or Egypt, where it is 24 percent and 32 percent, respectively, that have withdrawn costly price subsidies and whose currencies have fallen sharply in value, making imported goods more expensive. In Britain rising import prices linked to a weaker pound have added around 0.75 percentage points to inflation, which is 3 percent.
A second influence on inflation is the public’s expectations. Businesses will be more inclined to push up their prices and employees to bid for fatter paychecks if they believe inflation will rise.
How these expectations are formed is not well understood, however. The measures that are available are broadly consistent with the central bank’s inflation target in most rich economies. Japan is something of an outlier. It has struggled to meet its 2-percent inflation target, in large part because companies and employees have become conditioned to expect a lower rate of inflation. Prime Minister Shinzo Abe recently called for companies to raise wages by 3 percent in next spring’s wage round to kick-start inflation.
Leave aside the transient effects of import prices, and inflation becomes a tug-of-war between expectations and a third big influence, the amount of slack in the economy. The unemployment rate, a measure of labor-market slack, is the most-used gauge. As the economy approaches full employment, the scarcity of workers ought to put upward pressure on wages, which companies then pass on in higher prices. By some measures Japan’s labor market is as tight as it has been since the 1970s. America’s jobless rate, at 4.2 percent, is the lowest in more than 16 years. Even so, inflation has been surprisingly weak.
© 2017 Economist Newspaper Ltd., London (November 4). All rights reserved. Reprinted with permission.
Image credits: Emmanuel Dunand/Agence France-Presse/Getty Images