What you think is going to happen with inflation matters (a lot) to the European Central Bank (ECB). Indeed, this issue will – no doubt – be the subject of heated debates in Frankfurt next Thursday, when eurozone central bankers will decide whether or not to raise interest rates once again.. Something that has a full impact on the mortgage payments that almost four million families in Spain pay each month and, less obviously, on all economic activity in the eurozone.
What we expect to happen with prices in the future – that is, our expectations – is as important or even more important for central banks than the inflation data that is known each month.. Because, although it may seem like an exaggeration, the perceptions that households and companies have about how prices will evolve in the coming months or years can end up coming true in the manner of a self-fulfilling prophecy.
That's why central banks around the world put so much emphasis on the importance of keeping inflation expectations “anchored.”. A recurring term in the jargon of central banks and that the president of the ECB, Christine Lagarde, has used on numerous occasions. The last one, last Monday, when he highlighted the importance of effective communication “to ensure that medium-term inflation expectations remain anchored,” he noted.
But what does Lagarde mean by that “anchorage”? We are talking about inflation expectations being anchored when the opinion of families and companies about the future of prices is aligned with the ECB's objectives.. That is, when both broadly agree in their expectations with the 2% medium-term goal pursued by the European Central Bank.
Family expectations are measured through monthly surveys prepared by the ECB. In the last one, published last Tuesday, a slight rise of one tenth in 3-year expectations and inflation was recorded to 2.4%, four tenths above the ECB's claims.
A movement that, however insignificant it may seem, can tip the balance towards a new rate hike next Thursday. This is what ING analysts believe, for example, who believe that this very slight rebound gives arguments to the most cautious members of the ECB who are betting on a new rate hike.
Furthermore, the complexity of the eurozone economy – with 20 different fiscal and economic policies – adds further difficulty to the ECB's task.. For example, while families in Spain or France believe that inflation within three years will be around 2% year-on-year, in Italy – which has suffered more from the consequences of the war – households place it at 3%.
Why does what we think matter so much?
The power of expectations lies in their ability to come true.. People's beliefs, justified or not, about inflation condition their decisions. And this has effects on the economy. “If workers think that inflation will remain high, they will expect higher salaries and employers will raise prices thinking that costs eat into margins,” says Javier Ferri, researcher at Fedea and professor at the University of Valencia.
When inflation is low, citizens tend to pay little attention to price increases. This is what it has been like between the great recession and the pandemic. However, when we experience episodes of rapid and abrupt increases like the current one, awareness of inflation increases.. That is when there is a risk that the perception will establish among households and companies that prices will remain high for a long time.
If expectations become unanchored, workers will tend to ask for higher salary increases, which in turn raise the costs of companies, which may respond by raising sales prices.. Its perception also conditions important decisions such as the hours worked, the purchase of real estate, savings or consumption.
On the business side, inflation expectations are the basis for making future decisions. Pricing, investment, contracting…. are planned based on expected inflation. In addition, expectations also affect the signing of certain long-term supply contracts.. All of this could end up unleashing the feared inflationary spiral.
“If you live in an environment in which you expect prices to rise constantly, you are going to react accordingly,” summarizes Manuel Hidalgo, professor of economics at Pablo Olavide University and researcher at Esade.. Hidalgo gives Argentina as an example, where the year-on-year increase in prices exceeds 100%. “[In Argentina] your life is oriented towards seeing how you act optimally in a context in which prices constantly change,” he adds. “The way to fight inflation is to kill expectations,” he concludes.
A question of credibility
In the end, inflation expectations are still an implicit reflection of the credibility that citizens give to central banks. “A central bank that is not credible, due to having a very undemanding past, will make long-term inflation expectations higher, which in addition to influencing current inflation will mean higher interest rates,” he points out. María Jesús Fernández, senior economist at Funcas.
This partly explains why the ECB is being so tough on rate hikes.. The danger to their credibility of falling short and risking entrenched inflation is outweighing the risk of going too far with rates and triggering a eurozone recession.. A scenario that cannot be ruled out in the coming months, given the latest GDP readings in the eurozone.
At the moment, the data indicates that the situation is under control. Expectations for price increases in the medium term remain close to 2%. Furthermore, inflation in the eurozone stands at 6.1%, still high, but increasingly further away from the maximum of 10.6% recorded in October of last year.. What is more worrying is the slowness with which the core is reduced, the indicator that discounts the prices of energy, food, alcohol and tobacco. This indicator still remains at 5.3%, just four tenths below the maximum reached in March of this year.
Of course, price control is being achieved at the cost of damaging the economy. A damage that is becoming more and more evident. The latest growth data in the eurozone paint a picture of stagnation. The euro economy froze in the second quarter and the forecasts for the second half of 2023 are not very promising.