 Welcome to the European Central Bank podcast bringing you insights into the world of economics and central banking. My name is Michael Steen and in this episode we'll be talking about inflation. This is the measure of the increase in prices of goods and services over time and it is the key thing that most central banks look at. A bit like Goldilocks in the fairytale finding bears porridge that is neither too hot nor too cold. Globally central banks want to find a balance on inflation. There should be a little but definitely not too much. And whereas in the 1970s it seemed that there was definitely far too much inflation these days economists are puzzling over why inflation has been so low and at times even too low. So in this episode we wanted to explore this topic. Why should prices go up? What drives inflation and what does the ECB do to keep prices stable? My first guest today is ECB executive board member and chief economist Philip R. Lane. Philip welcome to the podcast. Thank you for having me. Can we start with just a very basic definition of inflation? What it means is how much prices over time go up. So if you like if you think about the euro in your pocket today how much you can buy what one euro today is quite different to 20 years ago when the euro started. So we're okay with prices going up a little bit every year. In fact if prices did not go up a little bit every year it causes its own problems and maybe we can come back to that. But equally it really is damaging to the economy is damaging to families is damaging to corporations if inflation goes up too quickly. So as you say it's to strike the balance. The world history tells us many episodes where too high inflation has been very damaging. What we face right now is the challenge of inflation that is too low and it's really an interesting time to work in a central bank because I think we more or less know how to fix inflation that is too high. Fixing inflation that is too low brings its own new challenges. Okay. So let's talk about the too low challenge a little bit. I mean I think it's counterintuitive for lots of people. You know people would think well prices are not going up that's good isn't it? It is definitely good news for as of today's if you took a snapshot today and you asked someone which do you prefer? Do you prefer prices to be flat or even falling or do you prefer prices to go up? Of course the answer is you prefer prices to be flat or falling. But when you take into account the whole economy and we take into account what happens over time then it becomes a problem. Let's take your typical worker and there's a deep connection between what's happening to prices and what's happening to wages. So if you rephrase that question and said I'm going to tell you that your wage is going to go up more slowly over time what's going to be your attitude? So I'm not so happy about that no more pay rises. Well you know with the economy getting more productive over time there would be wage rises. Okay. But there is I think a problem which is you know in the end when we get to it why do we want inflation to be closed towards two and not stuck at one or even falling towards zero? Why we want that is it if you like to use a phrase it's provide some oil in the economy some lubricant. If you have a system where everyone is expecting prices to go up a little bit every year then it turns out I mean this is the historical evidence it turns out the economy moves more smoothly and in particular and this is really I think the most important issue is let's say some bad news arrives. Let's say there's a recession in the future. If going into that recession you have inflation where it should be in the neighborhood of 2% then what that means is the ability of us as the European Central Bank to stabilize the economy to stabilize prices when there's a negative shock is so much greater than inflation we're stuck at one or zero so it really provides the resilience in the economy it allows the ECB to provide a guarantee of stability this is very much a stability orientated central bank and for that stability the paradox maybe is either want to stabilize around zero you want to stabilize around a number more or less 2% by the way every central bank in the world has reached the same conclusion at 2% is the target for the Federal Reserve the People's Bank of China Bank of Canada Bank of England everywhere there's a strong consensus on this the ECB formulation is close to below 2% but that's ballpark very similar I see so I mean and as you say there is this huge global consensus around the 2% figure those although there's also been a bit of debate hasn't there about some people saying shouldn't it be more some people particularly here where we are at the moment in Germany saying shouldn't it be less maybe just tease out that point again on if it was lower what is it that and the and the central bank faces a shock how is the central central bank then constrained in how it can act so one of the strongest laws of economics is the direct connection between inflation and interest rates so if you have a world where inflation is hovering around 2 and let's say underneath that in terms of the underlying real performance of the economy what we called a real rate of interest is also let's say 2 put that together then you would have our policy rate the ECB rate around 4 so if in good times you have an interest rate at 4 then when a bad shock happens you can imagine we can do a lot of monetary accommodation we can cut the interest rate from 4 all the way down close to 0 if instead you start with where inflation at 0 even if the underlying economy is similar then the peak interest rate is at 2 and the your ability to fight a down negative shock is so much less so again it's a very interesting issue because of course as of today you know is it a big problem to have inflation at 1 it's not a problem as of today but it does mean if there's a problem a negative shock in the future a slowdown in the future we would be less effective and another aspect is of course in terms of where we're when we're looking at our inflation objective we talk famously of this medium term so it's not what inflation is right now we're looking ahead a little bit can you explain why is that element important so the I think the two elements to that one is again it's very solidly founded in evidence that the our monetary policy decisions take a while to hit the economy because essentially we are changing conditions in the financial markets you or I are not directly trading in terms of the financial market so what we have to rely on is how the banks on those markets convert the financial conditions they see in the money market into your mortgage rate your rate for a car loan at the rate of lending to a small and medium enterprise and so on so all of that takes time and then in turn a firm may have a decision process it may take a number of months to say okay we we see these lending rates are lower let's make a plan to do more investment that takes time a consumer may take time say well let's let's do a home renovation that takes time to work out we also know that sometimes inflation dynamics are quite gradual which is definitely true at the moment and that's why we are patient in hitting our targets in other times inflation dynamics can be quite intense and so the medium term I think is an appropriate formulation it conveys that it's not overnight but conveys the urgency is that it's not ten years from now we care about and that's why you need the patience but turning a bit back to the the ECB then that you we talked already about how global central banks all converge around this roughly 2% inflation objective and the ECB of course we have the treaty defines our mandate as price stability the ECB's governing council then at some point decided that was close to but below 2% how does that evolve over time is there anything that needs to change there there's been talked by president Mario Draghi about some kind of review of the of the framework coming up how do you see this and you know to what extent should we be adjusting what we're doing so the last major review of the target was in 2003 which is 16 years ago so I think any organization probably wants to review its strategy more frequently than that now the good reasons why there's been a delay I mean most obviously the global crisis that really kicked off in 07 and 08 has meant there were other priorities I mean if to be honest I mean I think for a long time that formulation of close to but below 2% was essentially so close to 2% that maybe it didn't matter so when for example the Federal Reserve adopted 2% in 2012 is there a big difference between saying our target is 2 versus saying our target is below but close to I think that's something for review to reflect upon but I think it's cannot be doubted any difference between those formulations is more salient when you're have inflation below target because the question is what is enough it made sense at the time so the founding fathers of the euro area did the imperative in the early years of the euro was to make sure everyone understood that inflation above 2% would not be tolerated because of course many countries had a history of high inflation so the formulation at that time I think send a good signal that we really want inflation not to exceed to right now the bigger issue I think now is convincing everyone that inflation will return to the target whether you're hitting a target of close to but below 2% or be more precise about a 2% target that is something we're discussing in a review Philip thank you very much joining us my pleasure our next guests are Christiana Nickel and Frank Smetz Christiana and her team are in charge of monitoring and analyzing inflation and wage developments in the euro area she's done a lot of research on the causes of low inflation and low wage growth but also on structural drivers of inflation like demography and globalization Frank has worked at the ECB for over 20 years in a number of senior positions including time as an advisor to president Mario Draghi he now manages the teams in charge of forecasting economic developments and policies and he even has an inflation model named after him this work involves monitoring and analyzing inflation data and advising the ECB's governing council on monetary policy decisions now in the previous conversation we already mentioned that inflation is obviously at the very core of what we do as a central bank but what does it mean in practice so Christiana if I can turn to you to start with can you tell us a little bit about how price developments are measured and how does this translate into defining monetary policy now in the euro area we measure this consumer price inflation by the harmonized index of consumer prices the HICP and the term harmonized denotes the fact that all the countries in the European Union follow the same methodology this ensures that the data for one country can be compared with the data for another this HICP is not calculated by us by the ECB but by the national statistical institutes for each euro area country and it's later on then added up also by euro stat now when you look at what is covered by this HICP it is exactly like this idea of going to the supermarket and shop for a basket of goods it measures the average change over time in the prices paid by households for a specific regularly updated basket of consumer goods and services who decides it what's in the basket it's basically the national statistical institutes that decide what is representative also for their country and they regularly update this basket of goods so that it basically stays also up-to-date with latest developments in how also consumer behavior changes okay so the different countries might have slightly different baskets yes but still it's harmonized in the sense that each country doesn't deviate too much let's say from the common standard that we have for the whole of the European Union and crucially not done by us so we're not sort of marking our own homework no exactly now maybe turning to Frank Philippe Lane touched on the point that prices have been rising a bit more slowly in the past years and what actually makes the prices rise in the first place and why is inflation been so low recently well there are many factors that can lead to rising wages and prices probably the most popular framework to explain changes in inflation is the so-called Phillips curve this is a model that was named after Professor Phillips who was an economist at the London School of Economics in the 1950s who at that time noted a clear negative relationship between unemployment and wage inflation so when few people are looking for work and the labor market is tight then it then the employers have to raise wages to attract those workers and inflation is high and the reverse if an employment is high the ability of workers to demand higher wages will be limited and inflation will be low remember unemployment in the euro area was more than 12% at its peak in 2013 and that put downward pressure on wages and inflation but then as the economy recovered partly also because of the stimulus by the central bank people get employed and unemployment fell to levels that are now close to where they were before the crisis and so also wages and prices started to recover and so wage inflation now is basically back to average levels what's still missing a little bit is price inflation so the past through from wages to inflation has been a bit slower than usually there is a debate about whether the Phillips curve is dead which is a vibrant debate in the academic literature if you want to know more about that you can look at an inflation conference that Christiana organized a couple of weeks ago and two of the keynote speakers came with a definite answer that at least in the euro area the Phillips curve is alive and kicking and therefore we're also quite confident that as the economy further recovers and continues to grow inflation will eventually also converge to 2% so there's a there's a process here we had the crisis we had huge unemployment unemployment is now been going down a lot that means that wages have started to go up and now you would expect prices to come up afterwards is that is that a fair sign yes now of course there there are other factors also that determine inflation and that's some of these factors have actually put a lid on inflation one very important one is oil prices because that is a very volatile price which is basically determined in international commodity markets but has a direct impact on the cost of energy and so that is another factor that has actually had a downward impact on inflation of the past three to four years particularly because of course there are demand and supply factors in the oil market but the new technology such as fracking technology has actually increased the supply of oil and put down yeah and of course everyone needs energy to heat the houses or move around for transport and so on so that's why that's such a big factor yes it's one of the bigger components in the price index that Cristiana mentioned there's some other things at work here on a Cristiana like and the so-called structural factors where we start talking about things like globalization aging populations and even e-commerce and can you talk us through some of those aspects and some of the work that you've done I mean most importantly I would like to say upfront that's still what Frank just mentioned you know the drivers of the Phillips Curves are still I think the most important way of explaining inflation as we see it today however there are these other factors that you mentioned these structural factors in addition to the cyclical factors for example you have e-commerce and digitalization that have become much more important in recent year so for example digitalization poses a challenge to the measurement of inflation just think of Netflix or Spotify and these new offers replace the traditional products like CDs and DVDs now with these new products it's of course difficult to know what will be the weight in the basket and it is also difficult to know exactly how to basically price these new products it's just an example of how difficult it is to really keep this basket basically up to date and if you look at the rise of e-commerce and online shopping we also know that nowadays it's much easier to compare prices with each other because you know what is online and you can actually also go to the supermarket or to the shop and negotiate for your price and with this kind of competition actually also put basically a lid on how much prices can adjust because that's people literally standing in the shop with their smartphone to the shopkeeper look I can get this from here for this will you match the price exactly exactly and these are kind of indirect effects of e-commerce or digitalization and they are also difficult to measure let's say by the usual way we have our harmonized index of consumer prices and that we normally look at we find overall that there has been a small negative effect of e-commerce on inflation but this effect is hard to pin down using only the data that is at an aggregated level and this is why we also have efforts in the ECB to actually look at more disaggregated data and data that in particular comes from the internet aging populations why would that have an effect on inflation we've seen that the structure of the of the of the population has very much changed in the last 40 years and and if you look at population aging one example that springs to mind is Japan where quite a number of studies have pointed out that demographic fix has been a deflationary force and if you look at the my demographic developments in Europe we see that there is a positive long-run relationship between inflation and the growth rate of the working age population now why is that one reason is for example or could be that indeed let's say the savings behavior of people has changed because you know that you live longer you also save more and spend less and spend less and that of course has then an impact also on inflation at the aggregate but I just wanted to to point out that with demographics we are still let's say at the very early stages of research the jury is still out because of course demographics is an development that is very slow therefore not easy to capture like in frameworks like in the Philips curve and we also know that we will move to a new equilibrium with demographics so at some point these impact that we see may actually come to an end or may not be as strong as we maybe see it at the moment so tell us a little bit about globalization how does it how is that affecting inflation around in particularly in the euro area we have seen more globalization and integration in global value change and this might increase the dependence of domestic inflation on global developments for example if you look at global value chains we know that nowadays companies can produce their inputs all across the world and if a company in Germany sees that it can get its imported goods from somewhere else or can produce in a different production facility somewhere else in the world it basically gets the input then from the cheapest possible country that of course will also reduce costs and eventually might also lead to lower costs in the production of this good so we've seen that these these are all big changes big structural changes now a phrase that you sometimes hear or read is this thing about new normal does that mean that lower inflation is the new normal no i think many of these structural changes are one-off changes that have persistent but typically temporary effects on inflation christianna anything to add to that i would say that as frank already mentioned these are long-run but also drivers that eventually should lead to some kind of new equilibrium so for example e-commerce is a factor where not every shop will close just because it's there's online pricing we've seen it in the u.s. that there has been a rather strong impact of online purchases in the past but this effect has been slowing down so in other words it just needs a bit more patience so that we basically see that eventually also inflation may rise again so turning back to the ecb and particularly your two jobs and i think it would be this is a great moment since we've got you on the podcast to ask you about this one of one of the things that the ecb obviously does to when it's trying to set monetary policies to forecast or project where inflation is going to go you're both closely involved in that whole exercise can you talk us through that a little bit yes we produce basically forecasts for economic growth inflation employment wages and a whole host of economic and macroeconomic variables four times a year typically in march june september and december um these uh twice a year these forecasts are actually done by the national central banks and the role of the ecb is to basically aggregate give feedback and aggregate the numbers in a euro area uh forecast that's in june and december and twice a year it's basically an update that is being done by the ecb itself again in consultation with the national central banks because of course those central banks have a lot of the intimate knowledge of of their economy which improves our analysis and in our forecasts the horizon of our forecasts of our macroeconomic projections as we call them is between two and three years and the further away is the harder it is i mean to be a bit mean i mean we're often criticized for getting them wrong i think that's the same for for all forecasts everywhere but so can you explain a bit the the difficulty in this exercise well i mean that's that's of course the difficulty of any forecast um and there's basically two main sources of the forecast errors that we make i mean the first source is that i mean the economy is subject to news and shocks all the time and by definition news is not forecastable so if there's no developments on trade tariffs in the trade war that can have an impact on on the economy through the effect of uncertainty on investment and on trade and basically lead our forecast of inflation to to fall now as long as we don't have that news we can't really tell that this effect will be there so there's a lot of uncertainty about those shocks that affect this another example is the oil prices if a war starts in the middle east and that immediately has an impact on oil prices oil prices will increase and that will have an effect on on on energy prices and inflation so that's that's probably the most important source when we try to decompose why do we make errors it's often because we haven't foreseen what happened to energy prices or food prices which are very volatile and respond to factors we cannot forecast such as the weather for example the other part is and this comes back to the previous discussion that of course the way the economy works changes all the time and of course when we do a forecast we look at the data and we use our models macroeconomic models to interpret those data and forecast what will happen to economic growth and inflation now these models are based on historical regularities they are estimated on the past and of course the future doesn't have to be like the past as we've discussed globalization has changed some of the effects imported inflation similarly e-commerce has an impact on how firms set their prices and so in our forecasting process we have to continuously update our models in order to to sort of keep track of the changing economy actually that's one of the reasons why the third important element of any forecast is judgment that's really all the information that we cannot capture by the standard data or by the standard models and that's nevertheless important in forming a view of on the inflation outlook why is it so important as a central bank that we're doing these forecasts and that we're getting them as accurate as we can well the forecasts are a summary of the inflation outlook and the economic outlook of the euro area and therefore a very important input for the monetary policy deliberations of the governing council and forecasts are important because as we mentioned before monetary policy works with a lack when the governing council reduces the interest rate now then this has an impact on growth a year out and on inflation two to three years out so in order to stabilize inflation we need to know what inflation but our view is on inflation two to three years out and that is really given by the forecast okay great well frank christiana good luck with a ongoing challenging role that you have and thanks a lot for joining us on the podcast today thank you thank you that's just about it for this episode it's been fascinating to hear from my expert guests philip lane christiana nickle and frank smiths we're working hard at the ecb trying to keep inflation in that goldilocks zone not too hot not too cold neither too low nor too high and we've discussed a little bit how this all works in practice what inflation means to you how price developments are measured and the structural issues that can make it such a tricky job do also look in the show notes for links to relevant papers and publications from the ecb and if you have any thoughts on this episode or suggestions for topics you'd like us to cover in future episodes you can get in touch with us on social media via direct messages and comments you've been listening to the ecb podcast with michael steen if you like what you've heard please subscribe and leave us a review until next time thanks for listening