Christian Noyer: Is inflation set for a comeback?
Speech by Mr Christian Noyer, Governor of the Bank of France, at Deutsche Bank, Paris,
19 March 2008.
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With inflation surging everywhere, it is quite natural to wonder if we could have reached the
end of this worldwide era of "great moderation" in both output and price volatility which has
characterized Alan Greenspan's tenure of office.
True, one could argue that we are just experiencing one-off shocks in commodity and food
prices whose inflationary consequences will wane rapidly thanks to the increased flexibility of
our economies.
But other possible scenarios are more worrying. Second-round effects could, after years of
relatively well contained wages, be triggered by shifts in inflation expectations; through the
catching-up of developing economy, the globalisation process could have become
inflationary; the ageing of our developed European economy, the necessary fight against
global warming could structurally add inflationary pressures,.... and the room for monetary
policy decisions could be restricted by the state of the financial and banking system and by
the risks of slowdown of growth.
I would like to review these issues. In order to avoid any misunderstanding let me
immediately make my point. Even if it is clear that inflationary pressures have both increased
and changed in their nature, I firmly believe that monetary policy can still ensure price
stability, over the medium term.
My central scenario for the short term is a scenario where after a couple of months inflation
will recede in the euro area and come back "below but close to 2%" in accordance with our
definition of price stability.
It is not unusual to witness commodity and consumer prices acceleration in the initial phase
of an economic slowdown, as there is some inertia in employment and commodity prices
dynamics with respect to activity. This has happened previously at the end of the 1990s, with
a subsequent moderation in inflation.
In the short run, recent inflationary shocks are likely to maintain inflation at a high level for
most of 2008 as we may expect a significant degree of persistence in energy, industrial
commodity or some food price increases (such as meat). In the euro area, HICP inflation has
reached 3.3% in February. It might remain well above 2% in the coming months but ebbs
later this year according to ECB staff forecasts. These projections rely on a scenario of
global economic slowdown and moderation in commodity prices, which would contain
pressures on capacity utilisation in the labour and product markets. They are all the more
credible than we do not see at this juncture a major diffusion of price increases: less than
30% of the consumption basket (energy and food) are responsible for more than 60% of the
overall increase.
There are nevertheless some upside risks to these projections.
First, further shocks on food and commodity prices cannot be ruled out. On the demand side,
should emerging countries decouple to a large extend from the United States, their
contributions would then be sufficient to maintain a significant pace of commodity prices
growth. On the supply side, unexpected climate or geopolitical disruptions may lead to
shocks on production, as in the past few years. On top of both factors, in the current context
of raising inflation and troubled financial markets, commodities attract a growing part of
investment, speeding up sometimes rather artificially their price increases.
Second, the triggering of possible second round effects is a well known source of concern for
the Governing Council of the ECB. The common desire of firms and households to offset
profit margin and purchasing power losses stemming from inflationary shocks may lead to a
wage-inflation spiral, ending in deteriorated output prospects and welfare losses to all
parties. One should however note that nothing significant has materialised at this juncture.
On the contrary, remunerations have remained well in line with productivity gains with, to
take an example, reference wages increasing by 0.3% in France during the fourth quarter of
last year.
From this point of view, protracted shocks to food and commodity prices put the anchoring of
inflation expectations and the credibility of monetary policy to the test. The recent upward
trend in European household and market expectations may be of some concern. However,
as emphasised in a forthcoming issue of the Banque de France monthly Bulletin1, which is
entirely devoted to various inflation related issues, currently available measures of inflation
expectations appear crude and limited in terms of information content to explain short run
wage formation or consumption dynamics. In practice, the Eurosystem has a prudent and
comprehensive approach when considering private agents' inflation expectations. While
taking into account a large range of expectations indicators, the Governing Council does not
react to them mechanistically.
A firm anchoring of inflation expectations is nevertheless crucial in order to take up the
challenges coming from the new inflationary environment.
Among the long-run evolutions that can be expected with a high degree of certainty, the
changing impact of globalisation on inflation, population ageing and climate change
constitute threats to price stability and major new challenges for monetary policy.
First, globalisation may turn out to be more inflationary in the future than in its early phase.
This was one of the issues addressed in the recent international symposium of the Banque
de France.
For over ten years, with the growing integration of our economies, powerful forces,
throughout the world, have been acting to enhance price stability. Each year, the integration
of millions of people into the world labour market has increased global production capacity, in
particular for tradable goods. For monetary policy in developed countries, this process has
been equivalent to a sequence of positive supply shocks that took the form of a spontaneous
decline in the import price of manufactured goods. All other things being equal, this
terms-oftrade gain has allowed for a lower inflation rate for a given capacity utilisation rate. More
fundamentally, and although things seem to be less straightforward in this area, it is possible
that the increasing openness of our economies have structurally changed the wage and cost
formation process in a manner that favours price stability. It is clear that heightened
competition triggered by imports reduces the market power of firms at the national level. But,
other more indirect effects are also detectable. According to studies carried out at the
Banque de France, to be published in our next Monthly Bulletin2, the disinflationary impact of
imports appears to be relatively independent of import volumes: the mere existence of
potential competition renders the markets, in the words of experts, more "contestable" and
influences behavioural patterns.
These disinflationary forces are still present. However, there are now other more powerful
forces that have the opposite effect.
First, a natural process of real appreciation of currencies in catching-up economies is taking
place, leading to upward pressures on the prices of their imports. Along with the catching-up
in terms of standard of living, the level of prices in emerging countries tends to converge to
the level of advanced countries through a combination of appreciating currency and higher
inflation. Although somewhat hampered by exchange rate policies in the past decade, it
seems to gather speed now with, as an example, the most needed faster appreciation of the
Renmibi and at the same time accelerating inflation in China. This process will affect import
prices of manufactured goods in developed economies.
Second, the growth of emerging market economies and the rise in the living standards of
their populations are also leading to a surge in the demand for natural resources, food and
energy, which logically has a strong and permanent impact on inflation.
Furthermore, by strengthening the magnitude of global shocks in relation to more specifically
domestic shocks and favouring the international transmission of the latter, globalisation
introduces a much greater synchronisation of inflationary cycles between countries, with the
ensuing risks of amplification.
Overall, the effects of globalisation have ceased - probably in the long term - to be
spontaneously disinflationary.
Other factors will add to the inflationary pressures in the medium to long run. Without
elaborating too long on them today, I want to mention in particular population ageing and
climate change.
The ageing of the population will lead to a significant increase in public spending, for
retirement pensions and health expenditure. At the same time, the growth in public
indebtedness during the past twenty years will require an adjustment at some point. Both
issues will lead to a mix of economic policy decisions and there may be a conflict between
firms and employees about the final burden sharing, with risks of a wage-inflation spiral.
Climate change could also have both a direct impact on prices, through disruptions in
production, and an indirect impact, through policy measures to curb down carbon dioxide
emissions.
Climate change, through unusual weather outcome - temperature, rain or unusual
seasonality - or disasters, would disturb climate sensitive productions such as food products
or electricity (e.g. hydroelectric energy). Scarcity of these products would then lead to
temporary overshooting in their prices.
Measures to curb down carbon dioxide emissions will have a direct impact on prices through
increases of indirect taxes and an indirect impact through the necessary adjustment of the
production process. This adjustment will involve heightened tensions on production
capacities, as part of the equipment stock will have to be discarded due to changing
regulations or due to increases in its operating costs with higher taxes. Some temporary
impact on inflation may therefore be expected during this process.
However, in the medium run, the challenge of climate change may lead to a significant
a minima
improvement in technological progress, which will lead to reduce energy
consumption and carbon dioxide emissions for a given level of output but could also
stimulate productivity growth. This inflationary impact highlighted before would then be offset
both by downward pressures on energy prices and by productivity acceleration.
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As we can see from this rapid review of risks factors to inflation in the short to the long run,
there is a clear upward bias to risks regarding inflation, which has to be taken into account by
economic policy.
It is thus all the more necessary to insure a proper degree of competition on product markets
and a well-functioning price system, inducing changes in consumption or production patterns
according to the relative scarcity of products. There are large margins of improvement with
respect to product market competition both in emerging and advanced countries.
In the euro area, the fulfilment of the Lisbon agenda objectives could have a significant
offsetting impact. Higher employment rates and acceleration in productivity would lead to
both less inflation and higher growth. The low current employment rates of the younger and
older workers provide a wide acceleration margin for European growth. The potential
catching-up of information technology use in the Euro area would lead to a substantial
increase in productivity growth. Both evolutions would significantly reduce the inflation
content of growth and help contain inflationary pressures.
However, most of the burden lies on central banks, as "inflation is always and everywhere a
monetary phenomenon". The current "two pillar" approach of the Governing Council with a
crosschecking between the economic and the monetary analysis has, I believe, permitted us
to deliver a stance of monetary policy which has been totally appropriate to the situation of
the euro zone. The anchoring of inflation expectations at a level consistent with price
stability, which is currently observed in the financial market, is therefore completely justified.
The years to come will give to the central bankers the opportunity to demonstrate that these
years of "great moderation" are not just the result of lucky circumstances but are largely due
to an improved monetary policy framework.