The surge in euro zone inflation is driven by transient factors but underlying trends remain weak, so the European Central Bank needs to maintain copious support for the economy, ECB chief economist Philip Lane said on Thursday.
Inflation has risen steadily this year and is likely to exceed the ECB’s nearly 2% target in the coming months, driven by rising energy costs, a tax hike, a potential surge in household consumption and technical factors related to the pandemic shock.
This has driven market-based inflation expectations to their highest level in over two years, seemingly a positive for the ECB, but Lane cautioned that markets may be getting ahead of the real economy and their overly quick pricing adjustment could actually threaten growth.
Firms and households change their expectations more slowly, so when only markets price in higher prices, borrowers face higher real interest rates, Lane argued in a blog post.
“Under this scenario, the net impact is a contraction in output and a decline in the projected inflation path,” Lane added.
Nominal and real yields have moved in opposite directions in recent weeks, with nominal yields moving up towards their pre-pandemic levels while real yields are trending down towards early-year lows.
But these market-based real yields may inaccurately reflect real inflation prospects, Lane argued, as they exhibit a “striking correlation” with oil price movements and the rise was not so much due to “true” inflation expectations.
Lane’s comments shed light on his focus on nominal yield movements and the ECB’s decision last month to step up stimulus even as market-based real yields were not far from lows hit early this year.
“The volatility of inflation during 2020-2021 can be largely attributed to the nature of the pandemic shock,” Lane said in blog post. “The medium-term outlook for inflation remains subdued, amid weak demand and substantial slack in labour and product markets.”
The ECB has long argued that it would look through this spike and economist expect no scaling back of central bank support any time soon.
Source: Reuters (Reporting by Balazs Koranyi; Editing by Francesco Canepa and Catherine Evans)