ECB Insight: Uncertainty About Inflation Outlook Leaves ECB Insiders Wondering, Too

18 November 2021

By David Barwick – FRANKFURT (Econostream) – The crucial element of next month’s monetary policy meeting of the European Central Bank Governing Council is the inflation outlook. As Eurosystem staff gear up to make their best guesstimate amid great uncertainty, various insiders shared with Econostream reasonably similar, though still quite tentative views about medium-term prospects for price pressures in the area.

The opinions of those Econostream spoke to were consistent - as we see it - with an increase in the projection for 2022 euro area HICP (1.7% as of September) to between 2% and 2.2%; with a hike in the forecast for 2023 (currently 1.5%) to at least 1.7%, more likely 1.8% and potentially even 1.9%; and with a forecast for 2024 (no previous estimate) of 1.5% or 1.6%, possibly even 1.7%, though very resistant to speculation.

‘We have registered some positive surprises over the last few months, important ones in terms of magnitude, and the feeling is that this is also going to have an impact on 2022’, one person said. ‘It is well accepted that the factors responsible for these surprises are going to be with us longer than initially expected.’

Another person said 2022 inflation below 2% would be ‘very surprising’, and that the more likely scenario was that it would be ‘significantly above’ in view of supply constraints.

But from the point of view of December, more interesting will be how the ECB sees euro area inflation in 2023 and, for the first time, 2024.

As for 2023 HICP, it is worth recalling that the ECB succeeded in raising more than a few eyebrows when, following the last forecast exercise in September, it grudgingly hiked that projection a mere 0.1 point to 1.5%.

Governing Council member François Villeroy de Galhau was not the first to imply that the updated 2023 forecast might not be worth all that much when he admitted on October 12 that it ‘may be at risk of being revised upwards by a few decimal points’.

Indeed, many neutral observers had expected the 2023 HICP projection to be hiked from 1.4% to 1.6%, if not 1.7%. One insider confessed on background to having been ‘a bit surprised’ as well. ‘I expected a bit higher’, he said.

There was no political decision to err on the downside, that person asserted in defence of the ECB. ‘After so many mistakes on the upside, for seven or eight years always over-forecasting inflation, staff now is trying to find very, very good reasons if they increase the forecast, and there are still a lot of uncertainties in the pipeline’, he said.

‘We do not know how long the shortages will last or what the inflation impact will be of new energy policies and changes in taxation, but I would not say that they’re deliberately holding back’, he said. ‘It’s just that when you are off for seven years in a row, then you are more cautious.’

‘From my perspective there is clearly an upside risk to that forecast’, he added.

That person also suggested that the 2024 forecast would be ‘slightly over 1.5%’ and in any case clearly below the ECB’s price stability target of 2%.

A second person voiced the suspicion that the 2023 forecast would probably come in below 2%, though he cast some doubt on the validity of such an outcome, identifying – like the first person – a tendency on the part of the ECB to underestimate developments.

Two other insiders expounded at length about the medium-term inflation outlook. Both agreed that uncertainty was very high, but the first of the two was somewhat more inclined to see price stability being undershot at the end of the projection horizon.

The answer to the ‘big question’ of how the 2023 and 2024 forecasts would turn out was ‘not obvious at all’, according to this person. For the current inflationary episode to be persistent would require second-round wage effects, but there were no clear signals of these so far, he said.

Moreover, towards the end of the projection horizon, an important element of the forecasts related to energy futures, he said. ‘What you have is a very marked negative trend for 2022 onwards’, he said. ‘So given the way we do the inflation forecast, if we take this signal at face value – of course we will apply our judgment to it – this is going to put disinflationary pressure on the second part of the projection horizon.’

An additional factor that was also more relevant towards the later part of the projection horizon was ‘all the underlying, secular disinflationary forces that have prevailed in the past decade and are probably still there with us’, he said.

Therefore, while there were reasons to expect ‘very high inflation rates this year and next year as well’, he said, ‘the link between what we see now and the end of the horizon is weaker.’

For 2024 in particular, he said, ‘it’s not obvious to me that we’re going to come out with something close to 2%, because then you have to tell a very solid story about second-round effects that you don’t see, and you also have to tell a solid story about what’s going to happen with the energy component, which is not obvious looking forwards.’

‘I haven’t seen any comprehensive argument at the level of the Governing Council on where inflation should be at the end of the projection horizon, because the big question mark has been the lack of clear signals so far on second-round effects’, he continued. ‘There is a very legitimate desire to see some second-round effects, because we need them to support expectations. It’s going to be an interesting exercise.’

The other person said he remained convinced that inflation would go back down, given the role being played in currently high inflation by effects related to one aspect or another of the pandemic and thus temporary.

Still, he was more open to the eventuality that inflation would turn out to be more persistent than expected, and offered a range of potential reasons, including a shift to more local supply chains, increased confidence on the part of producers about passing on higher prices to consumers and the impact of German pension hikes. And even if inflation came back down, that wouldn’t necessarily mean it would settle below 2%, he said.

The key to higher inflation remained second-round effects, he said. Although the reduced bargaining power of unions and diminished use of wage indexation argued against strong second-round effects, high uncertainty made it ‘tough to say with great certainty whether inflation will land above or below 2%’, he said.

Most likely, 2023 HICP would be ‘clsoe to 2%’, he said. He declined to hazard an estimate for 2024, noting that the high uncertainty made any speculation about the far end of the projection horizon subject to great doubt.

Of course, the ECB can always surprise even insiders. In particular, the meagre hike in the 2023 HICP forecast in September left not only external observers scratching their heads, but also many Eurosystem officials.