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MNI (London)
--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 intact.
     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.
     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
     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.
     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
     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:
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MNI London Bureau | +44 203-865-3812 |