Financial markets seemed to be surprised this week by the idea that tapering could happen. Tapering, however, will in our view, not mean tightening. If ECB President Draghi sticks to his earlier words that wage growth is the new lynchpin for the ECB, normalisation of monetary policy is still far away. Lacklustre wage growth is here to stay, making below target inflation for the rest of the decade a likely scenario.
At the press conference on 9 March, ECB President Draghi introduced a new semi-official target indicator for the ECB: wage growth. Even though the ECB’s official mandate has always been defined as price stability, Draghi brought attention to wage growth, calling it the new “lynchpin”.
From needle in the compass to lynchpin. This change in the ECB’s thinking is not a cheap way to maintain ultra-loose monetary policies, it is the best answer to an inflation universe that has increasingly become harder to understand and analyse. Central banks and experts struggle to factor in structural trends, such as globalisation, ageing and new technologies. These factors are probably all exerting downward pressure on inflation. But these are also factors which are hard to measure. Therefore, it makes sense to move to indicators with – hopefully – the smallest error margin, giving a good picture of domestic inflationary pressure.
This week, Draghi mentioned that most forces currently weighing on inflation are temporary. Andrew Haldane, Chief Economist of the Bank of England, stressed earlier this month the more permanent nature of structural factors. This shows that central bankers in the Western world are divided on the matter. Which factors are transitory, which are structural? And when does transitory actually become structural? It is as if all important central bankers have become like pilots trying to land a plane that does not have the right instruments. In this world, wage growth has become the single most important indicator as it probably represents the best proxy for domestic inflationary pressure.
If Draghi sticks to his word and wage growth remains the lynchpin for the ECB, loose monetary policy is here to stay. There are reasons to believe that wage growth in the Eurozone is bound to stay lacklustre: slack, sectoral and technological changes all argue against a fast pick-up in Eurozone growth. Ironically, the ECB’s current loose monetary policy and calls for structural reforms are at least temporarily reinforcing downward pressure on wages.
Low inflation will in our view not prevent the ECB from tapering next year. Bond scarcity and stronger growth will be the drivers behind such a decision. The ECB’s lynchpin does not necessarily offer arguments against tapering, but is clearly in favour of making sure that tapering will not mean tightening. This week’s market reaction has been a clear reminder for the ECB that steering market expectations is an extremely tough job to do.