Are inflation and economic activity out of sync in the euro area?

Article published in the Economic Review of June 2018

In recent years, advanced economies have generally recorded sustained economic growth combined with surprisingly low inflation. Many economists have therefore talked about the “missing inflation” puzzle, because accelerating economic activity usually goes hand in hand with inflation: increased expenditure exerts upward pressure on production and demand for labour, and that results in a rise in wages which is reflected in the prices of goods and services. In this article, the authors try to assess whether the link between economic activity and inflation actually still exists in the euro area, and how it compares with the United States and Japan.

In the United States, as the dual mandate of price stability and full employment of the central bank looked likely to be achieved, it was possible to start normalising monetary policy from 2015. Since then, the Federal Reserve thus gradually reduced the size of its balance sheet and raised policy rates several times. In contrast, in the Japanese economy persistently weak inflation still prevails, despite a favourable economic situation and an unemployment rate at record low.

The analysis shows that the low inflation in the euro area since 2013 is due mainly to the underutilisation of production capacity and a decline in import prices. In other words, there is still room for economic activity to pick up before triggering any price increases. Moreover, the low inflation is attributable partly to the earlier fall in prices of oil and other commodities, movements which were reversed several quarters ago. In that sense, the euro area is more like the United States, where the moderation of inflation is an essentially cyclical phenomenon, rather than Japan, where the moderation of inflation is essentially structural and relates to a downward shift in inflation expectations. 

Two main conclusions emerge from the analysis. First, as the underutilisation of production capacity dissipates, inflation in the euro area should revert to the ECB’s target, namely a rate below, but close to, 2%[1]. Next, to achieve that, monetary policy must continue to support the economic recovery by ensuring favourable financing conditions, but without creating an overheated economy.

[1] For more information about the inflation objective of the ECB, see Deroose M. and A. Stevens (2017), « Low inflation in the euro area: causes and consequences », NBB, Economic Review, June, 111 126.