Summary
In January 2020, the European Central Bank launched the long-awaited review of its monetary policy strategy. Originally planned to be completed by the end of the year, due to the unprecedented challenges posed by the corona crisis, it has recently been extended until mid-2021. The quantitative formulation of price stability will figure prominently in this. In that context, the Governing Council will have to deal with a critically important, yet often neglected question: is its current measure of inflation – the harmonised index of consumer prices (HICP) – an appropriate basis for monetary policy in the euro area?
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Update Magazine I/2020 |
1
Review of monetary policy strategy
Under the helm of the new president, Christine Lagarde, the ECB kicked off the long-awaited review of its monetary policy strategy, the first comprehensive evaluation since 2003. Over the course of this year and against the backdrop of rising public unease, the Governing Council will scrutinise the efficacy and growing side effects of an unprecedentedly expansive policy that ranges from negative policy rates to large-scale asset purchases. The significance of these aspects is growing even further as a result of the enormous monetary stimulus measures being introduced to combat the coronavirus pandemic. Among the numerous topics that need to be addressed by policymakers is the critically important, yet often neglected question: has their approach been predicated on a flawed inflation measure that overlooks owner-occupied housing costs, a key factor of consumer price inflation? If this turns out to be the case, it could mean eurozone interest rates will remain too low for too long, and nominal assets like bonds could be exposed to a hidden loss of purchasing power.
2
Inflation is in the eye of the beholder
Several prominent euro-zone inflation gauges have painted a picture of subdued price pressure for the past 10 years:
- Consumer prices, as measured by the harmonised index of consumer prices (HICP) – the preferred inflation measure of the ECB – rose by an average of 1.3% per year.
- The core inflation rate – excluding energy, food, alcohol and tobacco – rose by 1.1% per year.
- Both of these measurements significantly undershot the ECB’s inflation objective of “below, but close to 2%”.
Longer-term market-based inflation expectations have responded accordingly and dropped to new historical lows. But this “lowflation” perception has not been shared by euro-zone consumers, whose inflation expectations have consistently outpaced official measures (see Chart A/).
While part of this gap is caused by official price measures underrepresenting lower and middle-income households, which tend to face higher-than-average inflation due to their consumption patterns, additional factors may be at work.
A/ EUROZONE CONSUMER PRICE INFLATION AND INFLATION EXPECTATIONS
Year-over-year %
Source: Bloomberg, European Commission. Data as at December 2019.
This “lowflation” perception has not been shared by euro-zone consumers...
3
Disregard of owner-occupied housing costs
The most important reason for a potential underestimation of real-world price pressure by the HICP has been that it does not factor in owner-occupied housing costs. Compared with many other countries, most notably the United States, these and other housing costs in the eurozone index appear significantly underrepresented (see Chart B/).
Why are housing costs being excluded? The European Commission (EC) reviewed this topic in 2018 and – with the full backing of the ECB – cited two major factors:
- Because the HICP must cover actual monetary transactions of household final consumption expenditures only, extending its scope would lead to a highly controversial integration of asset prices in an index that should only reflect changes in goods and services prices.
- The available data about housing costs does not fulfil Eurostat’s required standards of frequency and timeliness.
B/ CONSUMER PRICE INDICES – ITEM WEIGHTS
Source: US Bureau of Labor Statistics, Eurostat. Data as at August 2019.
4
Downward inflation bias
We believe the EC’s reasons for excluding owner-occupied housing from the HICP are questionable – and they can still be addressed:
- While residential property represents a grey zone between a long-lived asset and a service that provides shelter, we believe that buildings and structures (but not land) should be treated in line with other durable consumer goods (like cars or furniture) that provide utility over multiple years.
- The current lack of timely availability of a comprehensive dataset should not justify the omission of all homeowner shelter costs. As with other economic indicators, Eurostat could solve this problem by using a flash estimate based on a sample of preliminary data.
Inclusion of owner-occupied housing (OOH) costs – which rose by an average of 3.4% year-over-year between Q3/2018 and Q3/2019 – would have significantly lifted the recent eurozone inflation trend (see Chart C/).Assuming the same share as in the US consumer price basket, headline HICP inflation would have run at an average annual rate of 1.8% instead of 1.4% during that period, and the core rate would have been 1.7% instead of 1.0%.
Aside from housing costs, other factors may have contributed to the understatement of eurozone inflation. For example, many durable goods have shorter life spans (a negative quality effect results from higher obsolescence), and items such as apparel undergo frequent fashion changes that can distort their prices. Eurostat has been ignoring these factors, which would otherwise have lifted inflation. At the same time, Eurostat has been accounting for other factors – such as qualityimprovements – that dampen inflation. While the appropriate weight is certainly up for debate, it is clear that completely excluding OOH has pushed down official measures of consumer inflation.
C/ EUROZONE CORE HICP POTENTIAL IMPACT OF OWNER-OCCUPIED HOUSING COSTS
Year-over-year % (4-quarter moving average)
Source: Bloomberg, Eurostat, Allianz Global Investors’ own calculations.
Data as at September 2019.
This has given rise to fears of fiscal dominance, where monetary policy will be increasingly subordinated to fiscal-financing requirements.
5
What underestimating inflation means for monetary policy
The reliance on a narrowly defined and downward-biased inflation measure has contributed to the ECB adopting its ultra-expansive monetary policy, with real-world impacts. Deposit rates are negative, and over the last five years there has been an unprecedented flood of liquidity from quantitative easing.
But worryingly, by maintaining this expansive stance, policymakers may have missed the opportunity to regain some wiggle room by starting to normalise policy. Moreover, the ECB’s reluctance to move away from its monetary-crisis mode has severely undermined its credibility and independence. Fears of fiscal dominance, in which monetary policy is increasingly subordinated to fiscal and financial policymaking, have become even more entrenched by the ECB’s announcement of fresh large-volume sovereign debt purchases in response to the corona crisis.
More subtly, by repeatedly drawing attention to low consumer price pressures and undershooting its price stability target, the ECB has helped erode longer-term inflation expectations of investors and economists. This has raised the risk that a more general disinflationary mindset could become a self-fulfilling prophecy over time.
The answer may be for the ECB to adopt a more inclusive inflation approach, which would help the central bank to do two important things:
- Meet its objectives by capturing real-world inflation. Owner-occupied housing costs are highly sensitive to changes in monetary policy, so including them in price measures would lower the probability of a sustained over or undershooting of the inflation target.
- Contain financial stability risks by strengthening the link between macroprudential policy and monetary policy. The rise in global asset prices over the past decade has been helped by unorthodox monetary policy, but the ensuing financial stability risks were primarily addressed by macroprudential policies such as countercyclical capital requirements or leverage caps for banks. Given that real-estate excesses have historically helped trigger financial crises, factoring housing costs into inflation measures would encourage the ECB to act pre-emptively with macroprudential and monetary-policy measures (commonly known as “leaning against the wind”) in times of a rapidly rising or falling real-estate market.
6
Beware “stealth devaluation” and rising financial-stability risks
The understatement of “true” inflation by official price measures is having far-reaching repercussions for investors, since bonds and other nominal assets could be exposed to a hidden loss of purchasing power. This “stealth devaluation” could aggravate the negative effects of financial repression, which helps governments reduce their real debt burdens but hurts savers.
Accordingly, investors should consider making an appropriate strategic allocation to an actively managed blend of real assets such as equities, real estate and commodities, which may be able to provide a proper inflation hedge and a means of diversification.
Having missed the opportunity to normalise monetary policy in recent years, the ECB's scope for monetary policymaking and the efficacy of the instruments remaining to address the corona crisis are severely limited. By continuing to focus on the incomplete HICP measure, the central bank would face an elevated risk of missing its official inflation target for several more years, despite running an overly expansive monetary policy. Let’s hope that the central bank’s policy review will guide policymakers to consider a more comprehensive inflation measure. Otherwise, investors should be braced for a prolonged period of negative interest rates accompanied by rising financial-stability risks.
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