Inflation is here, and this is how it is going to affect your pocket

Ignacio de la Torre. Professor. IE Business School

4 April 2017

The increase in interest rates in the US will have knock-on effects in Asia and Europe. If the ECB starts to taper quantitative easing, there will be more rises in interest rates, making it too expensive to change to a fixed rate mortgage.

Sabine Lautenschläger, former vice president of the German Central Bank and a member of the powerful ECB board of directors, said that she was delighted that inflation in the Eurozone was set to reach 1.8%. Such comments brought ferocious criticism from the press as well as from a large part of the general population.  Hence, German tabloid Bild put her photo on its front page alongside her statement and a headline saying “easy to say if your purse is full.” This comes as no surprise in a country like Germany, which still remembers how the hyperinflation of the nineteen twenties prevented Germans from drinking more than one beer per session, because by the time they had finished drinking the first the rate of inflation had already made the second unaffordable.  

Within a very short time we have gone from a scenario in which we were told to be worried that the western world was going the same way as Japan, which would result in much feared deflation, to a scenario in which inflation has made an appearance far faster than most analysts predicted.  This shift has given rise to intense rational and emotional debate, given that it could have a massive impact on our pockets, as Bild so rightly claims.

Before we do anything else let’s examine the facts. The rate of inflation in the Eurozone, which had been dormant for a long period of time, has suddenly gone up by 0.5% to 1.8%.  German inflation went up to 1.9%, Spanish to 3%, and French inflation to 1.6%. Generally speaking these are the highest rates seen in the last four years. Meanwhile Switzerland, which is outside the Eurozone, has seen its inflation enter positive numbers after four years of negative rates. Inflation rates in the UK, driven by the weak pound, have risen to 1.8%, while the subcomponents of prices paid, which are a good early indicator of future inflation, have seen the biggest rises since 1992. Outside Europe, the US has seen inflation rise to 2.5%, the highest rate in the last five years, and China has also seen a rate of 2.5%, also the highest seen in a long time. The case of China is perhaps more worrying given that in the past it served as a global deflation force by producing cheap goods based on a very low cost of labor. Big wage rises in recent years mean that China is now starting to export inflation as its industrial prices are going up by 6.9%, the highest rate in a long time.

It’s true that the rise in the price of energy has played an important role in all this, and that central banks tend to take more notice of underlying prices (not including energy and non-prepared food) when drawing up their monetary policy. Underlying inflation in Europe continues at 1.1%, and that of the US is currently at levels of 2.3% (1.6% if we take a statistical variation favored by the FED).  In any case this could be a dangerous trend, given that: a) although rates of underlying inflation are still at moderate levels, they are going up bit by bit; b) rising inflation tends to drive a demand by workers for rises in salary which could result in greater underlying inflation (“second round effect”), especially in a context of falling unemployment; c) as the surplus production capacity that appeared in Europe and the US as a result of the crisis disappears, companies will tend to raise prices; and finally, and perhaps most importantly, d) as credit supply to the private sector expands and accelerates the economy will heat up and inflation will start going up faster. Hence, by way of example, the advanced indicators of European growth (PMI) will be at their highest level in the last six years, and might indicate annual growth rates of more than 2%, something which is easily explained in an environment where credit supply is growing at an increasing rate.

In this context the central banks have to react more or less fast. The FED will debate raising interest rates this month and will, whatever happens, raise interest rates between three and four times this year, and will continue to do so over the next two years. Moreover, it’s highly likely that Yellen will initiate the process of reducing the FED’s balance of payments before the end of his mandate at the end of the year, in order to avoid his successor, proposed by Trump, having to take such a tricky decision.  Also, Europe’s good economic results will drive a change of monetary policy by the ECB, possibly towards summer, before the German elections.  It is not logical to grow at a rate of over 2%, see prices increase until they almost reach the ECB objective (2%), and to continue “printing” 60 billion euros a month.  The ECB will announce a tapering and rises in the rates of interest, and, therefore, in the Euribor, will arrive earlier than previously expected.

These processes will have a direct impact on our pockets. The FED’s moves will cause interest rates to rise in the short and long term in the US. As interest rates rise in the US, those of Asia and Europe will follow. If the ECB announces a tapering process, these rises will intensify in Europe. The practical result is that a few weeks later it will be prohibitively expense to change from a variable mortgage to a fixed rate, which will mean that we will be exposed to a high level of risk of the rise of the Euribor, which will come earlier just as I said, and will impact our mortgage payments in a way that we didn’t expect. Meanwhile, inflation that is rising faster than wages and pensions will reduce our purchasing power, which means that levels of consumerism will grow more slowly in Spain in 2017 than in 2016.  

The vast majority of analysists, including myself, predict that rising inflation will be contained at reasonable levels, and we will be able to avoid the terrible shocks of the seventies, that brought about the ruin of many a family and caused a major economic crisis.  

Despite all this, history has taught us that inflation is also a monetary phenomenon. In a world in which we have carried out the biggest monetary experiment of the last few thousand years, any forecast could be wrong, and whether or not Sabine Lautenschläger’s inflationary smile ends up frozen will depend on that.

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