The return of inflation
In July 2018, consumer price inflation in France exceeded the 2% mark measured in year-on-year terms for the first time since the beginning of 2012. However, the debate on the return of inflation proved short-lived as inflation fell back below 2% as soon as November 2018. In April 2019, it stood at 1.3%. How do we account for such fluctuations? What consequences do they have on savings, businesses and the economy? Hélène Baudchon, an economist at BNP Paribas, explains.
What does the return of inflation mean for the economy?
We talk about inflation when we see a widespread, sustained and self-sustaining rise in prices. The widespread aspect of price inflation is particularly important as it sheds light on why the rise in inflation in the summer of 2018, above the 2% mark for the first time since early 2012, did not really signal its return.
We can't start talking about inflation just because the price of a particular product, in this case oil, rises significantly and pushes up the overall consumer price index. In that scenario, it's price distortion, not inflation. To better understand the underlying trend in inflation (which is itself a gauge of the underlying economic trend), we need to ignore fluctuations in the prices of the most volatile products (energy and food) and instead look at changes in so-called core prices. In France, the national measure of core inflation is also adjusted for fiscal measures and public fares.
Inflation corresponds to a combination of three criteria: a widespread, sustainable and self-sustaining rise in prices.
However, this core inflation is still disappointingly low: in the summer of 2018, when headline inflation exceeded 2%, core inflation was just below the 1% mark. And when headline inflation started to fall in November 2018, driven by the drop in oil prices, core inflation was also on a downward trend. In April 2019, the last known point at the time of writing, headline inflation stood at 1.3% in year-on-year terms and core inflation at 0.7%.
Do these figures indicate a pick-up in business?
In theory, yes, higher inflation follows economic recovery, although this is not obvious in practice. If you look at today's price dynamics, signs are still weak. Between 2017 and 2018, we did indeed see an increase in core inflation (from an annual average of 0.4% to 0.8%), but the small scale of this increase continues to raise questions. It falls short of what was signalled by rising upstream inflationary pressures (output prices, delivery times, business leaders’ judgement on the general price outlook), by the growth strengthand by the start of wage acceleration. In addition to lacking the characteristic of being widespread, price dynamics also lack the characteristic of being sustainable and self-sustaining. In other words, we’re not seeing the wage-price spiral usually associated with recovery phases. Price and wage increases are not self-sustaining, or at least not yet, we’d like to believe.
Photo : Hélène Baudchon
Has this been followed by ‘core’ inflation and increased purchasing power?
No, core inflation has not kept pace with the rise in headline inflation. Between January and July 2018, the latter gained 1 percentage point (from 1.3% to 2.3% in year-on-year terms) while core inflation remained stable at 0.9%. This is a sign that the inflationary mechanism has not yet been set in motion, at least not in any tangible way. Hence the significant negative effect on purchasing power of an energy-led rise in inflation, without the mitigating effect of inflation driven in particular by wages.
Structural factors weigh on wage and inflation dynamics: globalisation, the rise of fixed term contracts, the digital revolution...
The disinflationary effect of the euro’s appreciation between mid-2017 and mid-2018 may be an explanatory factor behind the limited recovery in core inflation. Sector-based factors have also had an impact, such as cuts to France’s housing allowance scheme and a further sharp fall in the price of communication services, while second-round effects from the sharp rise in oil prices up until October 2018 (particularly as far as air fares are concerned) have not been in evidence.
On a more fundamental basis, low core inflation can also be attributed to efforts made by companies to control their margins, efforts that so far are sustainable because the rise in unit labour costs (labour costs adjusted for productivity gains) is recent and modest.
Structural factors are also weighing on wage and inflation dynamics and helping to loosen the wage-price spiral, which has led to core inflation that is still uncomfortably low. They’re a hotchpotch of globalisation, competition, competitiveness efforts, the rapid rise of fixed-term contracts, the expansion of the service sector, the decline in the rate of unionisation, the digital revolution, low productivity gains and population ageing.
Rising inflation is one of the warning signs of an end to a cycle.
Why is a high inflation rate usually associated with slower growth?
Because today’s high inflation is the consequence of yesterday’s strong growth, and the potential cause of lower current and future growth. Rising inflation is one of the warning signs of an end to a cycle: it’s the sign of an overheating economy, the next step being downturn and recession.
What are the consequences on savings and investment?
Higher inflation ends up having a negative effect on growth because it tends to reduce households’ purchasing power and therefore their consumption. In this case (the most common scenario), inflation pushes up personal savings. However, higher inflation can also result in lower savings in the event of ‘flight to cash’ behaviour, i.e. when households buy now to avoid paying higher prices later. This is what happens in situations of rampant inflation, which is far from being the case in developed countries in general, and France in particular.
On the corporate side, a more inflationary environment, in a context of stronger demand, can be favourable for companies for a while. This is the case when that more favourable economic environment eases the degree of competition and allows companies to raise their selling prices more substantially without too much risk of losing market share.
In the most common case, inflation pushes up household savings.
But when production costs increase (through increases in wages and intermediate consumption), inflation ends up having an adverse effect on companies’ margins and therefore on their expenditures (investment and hiring). Higher inflation is also associated with higher interest rates. The resulting rise in real interest rates also tends to curtail growth through tighter financing and credit conditions, which weigh on consumer and investment spending. The impact on personal savings is ambiguous: they may be stimulated by higher interest rates (which pay more) or remain unaffected (savings increase or hold steady simply because of their higher return). The macroeconomic impact that dominates is the one where savings increase in the event of higher interest rates and inflation.
The current situation, however, is peculiar in that higher inflation would be welcomed, at least temporarily. Rather than be a source of concern as to its negative impact on business, it would be a positive sign that the pick-up in growth is strong enough to be passed on to prices. More generally, it would be the sign of a more normal functioning of the economy.
Higher inflation is also associated with higher interest rates.
The ECB is holding back, even though the rise in interest rates is one of its goals. Why is that?
In the 1980s, central banks in the developed world successfully combated too-high inflation; now they are struggling with too-low inflation.
Strictly speaking, raising interest rates is not one of the ECB’s goals: no doubt it would like to be able to raise them as soon as possible, but it will only do so when it is sure that inflation in the euro zone is headed towards its target of inflation close to, but below, 2%. The ECB would have to believe that inflation was widespread, sustainable and self-sustaining, which was not the case in the summer of 2018 even though inflation exceeded 2% and nor is it the case today against a backdrop of a decline in headline inflation, core inflation softness and downside risks for growth.
There has been a notable reverse in the situation: having successfully combated too-high inflation in the 1980s, central banks in developed countries are now struggling with too-low inflation, a tough battle that we don't yet know if they will win.
According to forecasts by Banque de France, inflation is expected to fall again in 2019 before rising slightly in 2020. Why? And what will the consequences be?
In its latest forecasts, in March 2019, Banque de France predicted that inflation in France would average 1.3% annually in 2019 and 1.6% in 2020, after 2.1% in 2018 (harmonised measure). The expected fall in inflation in 2019 is essentially the result of an oil effect (expected to be lower, on average, than in 2018). As for core inflation, Banque de France expects it to hold steady at 0.9% (harmonised measure).
In 2019, this expected decline in headline inflation is one of the factors supporting households’ purchasing power (in addition to tax cuts) and, more generally, supporting growth. But that is without factoring in the sharp rise in oil prices since the beginning of the year, which is rocking the boat. Inflation could therefore be higher than forecast and the expected gains in households’ purchasing power in 2019 would be reduced accordingly. In 2020, assuming oil prices hold steady, the expected rise in headline inflation to 1.6% will be the result of the rise in core inflation (to 1.2%), itself the result of higher wage growth. In our view, this corresponds to good inflation, inflation that is favourable to growth, rather than detrimental, despite its rise.
In March 2019, the Banque de France predicted that inflation in France would average 1.3% annually in 2019.
Photo header ©Mike Mareen
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