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2018-11-08Macro `n Cheese

Quite a predicament

According to Roger, ECB is in quite the predicament. Activity indicators are easing. Inflation, especially the core kind, is very low. And yet, there is something else going on. Up-stream cost pressures are on the rise. How should the ECB interpret this? – To get Roger’s answer, read on!

A Colder Climate

Over the past year, most Euro Area activity indicators have receded and as late as a couple of weeks ago, I had a chart with PMI-data that showed a rather stark deterioration in the main Euro Area economies. Most other data also point in the same direction and – noteworthy – the outcomes keep coming in lower than what (even downward) revised expectations suggest.


That said, in the midst of all the poor activity data, Euro Area labor markets seem to hold up very well with the unemployment rate falling towards pre-crisis levels.


This also holds true for broader measures of unemployment, such as this from an ECB-bulletin last



The remaining distance to pre-crisis levels of unemployment according to the two graphs above is somewhere between ½-1 percentage points of the labor force. Consequently, and while still at (too) low levels, we are now seeing a more pronounced pick-up in wage growth (do compare with the US equivalent, just don’t forget to use similar time windows).


This also fits nicely with the conclusions from an article in the most recent ECB-bulletin. The article indicates that Euro Area potential GDP-growth has now, finally, recuperated to pre-crisis growth numbers implying that the global financial crisis was primarily a shock to the level of GDP (incomes) rather than a shock to the growth of incomes. If this is true, it quite underlines the hypothesis of long-run hysteresis effects from deep crisis that many academics are pushing. Furthermore, it fortifies the view that wage inflation is indeed picking up and will eventually and finally push up inflation to- and above -the inflation target.

But, yes, that is our problem here. Inflation is not picking up, at least when we control for food, energy and similar volatile measures.


And again, yes, you would be excused for thinking that this depends on improved productivity balancing out the rising costs. However…


Actual productivity growth is weak, and according to the ECB’s recent analysis mentioned above, this is mainly due to slow capital deepening (whereas total factor productivity is in line with pre-crisis trends), weak investments. Nonetheless, weak overall productivity implies that unit labor costs (ULC) are indeed on the rise.


This, arithmetically, equates to European companies currently experiencing a hit to their profit margins. While, historically, this has not tended to last but instead spilled over into higher prices as companies seek to protect their profits, maybe this time is different. Because the discussions now being held in corporate board rooms all over Europe, probably mirror those of the ECB’s governing council: We see rising upstream cost pressures, heralding higher prices and interest rates.

Simultaneously, however, general price developments are slow and – importantly – demand growth is decelerating.

Of course, in the secluded world of corporate board rooms, it will perhaps make sense to act on the first premise, protect profit margins. It is always possible to cut prices later.

For the ECB, though, with effects of decisions lingering for months and years, the ruminations are agonizingly difficult. Do they forecast (hope) that demand and inflation will pick up and embark on a hiking path? Or should they play it safe knowing very well that if they are wrong the ECB has shot themselves in the foot, again?

My view is that the ECB, along with my favorite peripheral CBs, will opt for the former. That said, I don’t necessarily think it’s a good idea in the midst of a slowdown and, worse, I think there will be both political and economic fallouts for the ECB for eschewing the safer option.

The ECB is in quite the predicament, if you ask me.



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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.