Another look at the link between inflation and interest rates

In Germany, since the creation of the EMU, inflation has never been so high, nor interest rates so low.

Contrary to previous years, investors started 2017 with some fears about inflation – not because of downside risk, but because of a possible shock to interest rates caused by an overshoot of the inflation rate.

The new headline is the following: for the first time since the great crisis, the economy of a significant developed country has normalized. The deflation risk has been fully removed and the word “recovery” could be replaced by the word “expansion”. Obviously, we are talking here about the US, which is, for the moment, the unique “zone” to have recovered with full employment.

For Europe, the picture is more complex. As a whole, the region is not threatened by a fast-rising inflation rate. However, the problem lies in the “as a whole” qualifier. The heterogeneity or diversity among European countries is so high that a global approach looks irrelevant.

Some economists argue that Europe is comparable to the US: the economic dynamism of California may be different to that of Wisconsin, but it is basically one entity. We disagree. Economic momentum may diverge across the US but critically, the institutional framework remains the same. In Europe, not only do the economic trajectories of countries vary, but the institutional frameworks are even more diverse. We are strongly convinced that the latter explains most of the former.

If overly high inflation could be a risk for the US in the coming quarters, we feel it is a distant risk in Europe generally. Yet once again, there is divergence across the region.

In Germany, if we look at an aggregate measure which combines the prices of goods, services and investments at household level, we get the series as shown in Chart 1:the price dynamic is at its strongest since the creation of European monetary union two decades ago. If there is a link between interest rates and inflation, German data over the past 20 years does not suggest it. The fact is that in Germany, since the creation of the EMU, inflation has never been so high, nor interest rates so low.

How is that possible? Here, we come up against the limits of monetary policy in a single currency area with inadequate economic objectives and constraints. In terms of inflation target, since the start of the euro, the 2% level has been exceeded by core CPI year-on-year only in 2002.

The implications of that are simple: interest rates have always been either too low or too high for most Eurozone members. Central bankers do not think globally but in ‘marginal’ terms, and because of their declared risk aversion, monetary policy is influenced first by the weakest members of the club. So in the 2000’s, interest rates were too low for Spain and too high for Germany. Today, interest rates are too low for Germany and too high for Italy.

Of course, some will say: “But what is the risk in having interest rates too low? That’s not a problem, we don’t care.” This is precisely the rationale of European Central Bank governor Mario Draghi, and it is hard to say he is wrong, because we have insufficient experience to assess whether distorting interest rates poses a real risk to long-term economic performance.

But perhaps we are about to find out. Economic theory teaches us that distortion ends when monetary policy is pressurized by economic data. This year should be interesting, because it seems the US economy is at this point.

The recovery of momentum of the US economy in recent months, without any support from the new administration, has been impressive. If oil is now poured on the fire i.e. if a budget policy designed for recession times is applied to an economy in full employment, we will learn a lot.

The relationship between the real economy, the formation of prices and monetary policy decisions will become much clearer. For the moment, we do not have this knowledge, we have only assumptions and doubts. The US bond market is probably in a similar mood, meaning that volatility could increase, as current yields do not represent a robust equilibrium.