MNI INSIGHT: ECB's Inflation Conundrum is Still Not Yet Solved

--Belief In Euro Tower Phillips Curve Will Reassert, But Caution

By Christian Vits

     FRANKFURT (MNI) - Despite the strength of the euro area economy, inflation

remains stubbornly subdued, posing an ongoing problem for the European Central

Bank's inflation targeting approach. 

     At the core of the debate is a seeming breakdown of the Phillips Curve as

price pressures are not triggered by falling unemployment, a concern noted by

policymakers, although at least one ECB policy maker told Market News the curve

is still in tact.

     ECB Governing Council member Ardo Hansson expressed this view in a recent

exclusive interview with MNI.

     "I think the Phillips curve is broadly intact. Maybe we have to look to

more global indicators than national ones. That might mean that we have to

refine it a bit," he said. 

     "But ultimately, when the economy is operating at full capacity, that

should translate into higher wage and price growth. It is hard to believe that

this would not be the case," he added

     But underlining the Bank's concerns, Peter Praet, the central bank's Chief

Economist, noted in a speech in October that there "still appears a disconnect

between growth and inflation." 

     "In an extreme scenario, the entrenchment of disinflationary developments

could sustain a downward drift in the Phillips curve and unmoor inflation

expectations," he told an audience in Washington, DC.

     The Phillips Curve is a single-equation empirical model and explains

inflation as a sum of three factors: inflation expectations, the economy's

output gap and a residual term. Put simply, the inverse relationship says that

lower unemployment rates correlate with higher inflation.

     It is a policy cornerstone for all inflation-targeting central banks,

therefore the dispute about a flattening of the curve or notions that the

correlation is no longer in tact anymore triggers fundamental concerns about

monetary policy.

     --INFLATION HEADWINDS

     There have been many headwinds to inflation over the past ten years, which

have all impacted on the traditionally accepted impact of the Phillips Curve.

     Firstly, damped inflation is a global phenomenon. Globalisation has lead to

more open trade, meaning that companies experience higher competition and

increased cost pressures with the result of cost and price cuts.

     What's more, companies can relative easily move their production to

low-cost locations. And, "higher import volumes due to increased globalisation

have increased the importance of international prices relative to domestic

prices, forcing domestic mark-ups to be less sensitive to the state of the

domestic economy," an ECB study, published in January, concluded.

     According to Ardo Hansson, "the fact matters that you can move production

to different places. That is a process which will last a few years and then will

die out".

     Secondly, the digital economy and e-commerce increased price-transparency

and competition.

     For instance, as Bank of Canada Governor Stephen Poloz recently pointed

out, mobile phone carriers began offering more unlimited-data plans, following a

significant drop in the cost of data.

     "Staff at the Bank of Canada estimate that special factors such as these

account for roughly two-thirds of the decline in US core inflation since the

start of this year," he said in a speech given in early September. "The impact

on inflation of these relative price changes should not persist -- in other

words, the underlying trend in US inflation is higher than it appears," he

underlined.

     At the same time, digitalisation can make businesses more efficient,

improving productivity and leading to lower price rises.

     Third, lower energy prices and migration have helped to maintain lower

levels of inflation than seen before, due to the overall fall of prices in the

consumer basket and increased labour supply.

     Fourth, demographics are playing a role. At the current juncture, a rising

share of the advanced economies' populations is now on working age, increasing

the relative supply of labour.

     Fifth, deregulation and labour market reforms have had their impact, not at

least that labour unions lost a fair amount of their bargaining power.

     Sixth, labour market evolvements most likely played a role. "Subdued wage

growth, larger involuntary part-time employment, higher incidence of temporary

contracts, declining hours per worker" may have as well had an impact to the

resilience of inflation during the past years, the IMF said in a study published

in October.

     Still, central bankers haven't lost their believe in the Phillips curve.

     "The closer we get to full output and employment, the greater the risk that

inflation pressures will appear," Poloz said. "The laws of supply and demand

have not been repealed," he added.

     --PHILLIPS CURVE REDUX

     Hansson accepts that the headwinds exist, but says they are unlikely to

impact medium-term inflation and that the Phillips Curve will reassert itself.

     "All these factors will have some impact in the next years, they are not

short-term," Hansson told Market News. 

     "But they will not affect medium-term inflation. There is an effect for

some years, but then, we will be back in a new normal, over the Phillips Curve

relationship will reassert itself. I think we have to be more patient on this,"

he added.

     Asked, whether we could see a re-emergence of inflation more rapidly than

currently perceived, Hansson said: "You can't rule out that the relationship

will reassert itself suddenly. I think it can't be ruled out, even as we do not

see any signs of it."

     Barclay's economists Tomasz Wieladek and Iaroslav Shelepko recently

examined the Phillips curve inflation link. They revealed that the output gap

was possibly underestimated and would therefore require a removal of monetary

accommodation.

     There is a clear risk that the Phillips Curve indeed remains intact and a

chance that inflation will creep up more rapidly than currently thought.

     The academic debate so far has not yielded a convincing conclusion on the

matter. But one thing is for sure: Monetary policy has become more difficult.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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