My colleague Tomoya Masanao recently told me Japan’s problem is that it cannot generate “good” inflation, by which he meant higher consumer prices driven by higher wages. The Bank of Japan’s huge bond-buying program weakened the yen, which temporarily pushed inflation up, but not wages.
Might Europe be experiencing a similar phenomenon?
Consumer price inflation in the eurozone slid back to -0.1% in September, i.e., deflation, a long way from the European Central Bank’s (ECB) target. Lower commodity prices are the key reason why headline inflation is so low. But even after stripping out energy and food, core inflation is still just 0.8%.
A major cause of low core inflation is the high rate of unemployment. Labor market reforms in recent years, mainly in southern Europe, have made inflation more sensitive to the level of unemployment. High unemployment now means low inflation, and the reforms have potentially lowered the level that unemployment has to fall to before wages and consumer prices start to rise.
Unemployment in the eurozone is currently 11%. The ECB’s inflation forecast for 2017 of 1.7% assumes unemployment will fall to 10.1%. The recent, more sensitive, relationship between unemployment and inflation suggests 10% unemployment is consistent with inflation below what the ECB forecasts, possibly as low as 1.2%.
Based on unemployment alone, we think eurozone unemployment would have to fall to about 8% – or possibly lower – to move inflation closer to the ECB’s target. The risk to the ECB’s inflation forecast is therefore to the downside, and consequently, the ECB will likely have to adjust its bond-buying program. We think it could increase the quantity of bonds purchased each month from €60 billion to perhaps €70 billion, and that it could extend its commitment to buy bonds beyond the current September 2016 deadline.
Whether or not such action will produce “good” inflation remains to be seen, a point I raised in my September blog post, “Eurozone Inflation Forecast: Getting Closer to Japan.” What seems likely is that it will keep interest rates low and generate more excess liquidity that could weaken the euro or find its way into financial assets.