Eurozone forward-looking indicators suggest the recovery accelerating, so much so that real GDP growth at 3% next year is a genuine possibility. Surveys on the outlook for prices also indicate a pick-up; but without an acceleration of commodities prices, Eurozone inflation is likely to remain right on the ECB’s target. However, there are at least four reasons, in our view, that perceived inflation is higher than the consumer price index is suggesting: higher depreciation; limitations in the way we measure inflation; the increasing importance of services, where there is inelastic demand; and the recovering housing market. These factors, in our view, contribute to the gap between rising confidence and actual household consumption growth. On the margin, this will mean that monetary policy is more likely to stay very accommodating for longer, which also implies that an eventual downturn in the business cycle may not only come as a result of a tightening central bank, but also via other regulatory measures.
The European Commission industrial confidence index has proved to be a good leading indicator of real GDP growth in the past 20 years, so we take its message seriously. In the latest September reading, the survey, in our view, opens the door to Eurozone growth as high as 3% next year. Of course, the strength of the Euro, and how the political and policymaking backdrop evolves will play an important role, which may keep growth slower, but the survey results are telling us that the Eurozone economy should grow meaningfully faster than the ECB’s current projections of 2.2% this year and 1.8% in 2018.
An equally good survey index from the EC on the industrial sector expected pricing power also suggests that inflationary pressures are building, but the way the consumer basket is constructed also implies that, unless commodity prices accelerate from the current levels, inflation will remain right on the ECB’s target in the coming 18 months. This should allow the ECB to orderly and gradually withdraw some QE stimulus, and very slowly begin to think about increasing interest rates, perhaps in late-2018E. Even in the most hawkish scenario of a 25bps increase by the ECB next year, de facto, the monetary stance would remain very accommodating.
Are we missing something? To some extent, yes, in our view. We believe there are at least four reasons that inflation – that is, what an average person on the street would identify as “increasing cost of living” – is higher than what we capture in the HICP (harmonized index of consumer prices).
First: higher depreciation of some goods. The faster an item loses its operational abilities, the more frequent we need to replace it. Think about how long your mobile telephone lasts these days (abstracting from the devilish impact of toddlers), how long some low/medium quality range of clothing or shoes last, how long simple housing/electrical/cheap furniture items survive… It appears to us that the average life expectancy of various goods is falling; in some cases, far shorter than in the past. This does not mean that cheap/short-lived items did not exist before, but rather that the availability of such items is greater than before.
Secondly: we do not capture everything in the HICP, in our view. Here, we can think of two likely limitations. First, in order to standardise and create the index, some simplifications need to be made, so national statistical offices aim to take the main price tag of an item or a service. However, in the age of big data, especially large companies have become very good at pricing their items in such a way that the consumer ends up paying more than they thought initially. This is the case for items where there is a de facto two-fee structure: the consumer pays for a service per unit usage, but also needs a subscription fee. If the company keeps the per usage fee unchanged, but increases the subscription fee, the consumer is paying more, but the inflation rate may not show it. Equally important could be other pricing strategies to capture the most from customers; think, for example, about airline carriers, which now charge for food and drinks on flights, or for checking in at the airport. Consumers do not need to use either service, but probably end up doing either or both out of desperation/anxiety. Why is this more important now than before? Because the age of “big data” and “optimal pricing strategy” has only really become widespread in the past 10 years – that is, after the last rate cutting cycle.
Thirdly: increasing reliance on services where the demand is fairly inelastic – think about private education, private healthcare insurance, banking costs or legal services. All things that, whether we like it or not, are becoming increasingly part of everyone’s life and which, on average, exhibit a higher inflation rate than the headline inflation number. Now, all these services are already included in the HICP index, so we do keep track of them. However, as their desirability increases, and given that their cost is significant, they could be influencing people’s decisions more than the CPI basket assumes as prudent families are probably saving to be able to afford (or continue to afford) these services in future. Therefore, they may not affect monthly budgets today, but the expectation of future needs may be affecting spending decisions anyway.
Last, but not least: rising housing costs. Rental costs and the maintenance of a house are already included in the HICP index, but it is well-acknowledged by statisticians and central bankers that our ability to measure these items is still limited. At a time of rising house prices pretty much everywhere in the Eurozone, we are probably underestimating the effects. In addition, the European authorities are trying to limit 100% loan-to-value mortgages, which implies that, for every 5% increase in average house prices, there is a very significant share of the population (at least those in the first two quintiles – that is, a minimum 40% of citizens) where the increase in the downpayment requires several years of additional savings. Again, this dynamic is not precisely captured in the way we measure the inflation rate, but it would be identified by the average person on the street as a source of “increased cost of living”.
Thus far this year, we have interviewed 500 people around Europe, asking for their views on their government’s performance and their policy priorities going forward. We were struck by the fact that, even in fast-GDP growth countries, such as Germany and Romania, a significant share of respondents complained about high prices, although the statistics would argue that purchasing power has improved on average. A mismeasurement of inflation – or what the average person understands as “inflation” – may be part of the explanation. If that is the case, then there are important policy implications that could be made. First, the central bank will remain “loose” for longer than needed. Secondly, eventually either the discontent will grow and thus show in voters’ preferences, or new policy responses may be put in place eventually, which could take the financial markets by surprise. More on this topic in the coming weeks…
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