Are US and euro inflation pressures parting ways?

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Americans are from Mars and Europeans from Venus, was the quip supposed to capture the two power centres’ approach to geopolitics. It could now be repurposed for another analytical shorthand. It looks likely that the Federal Reserve will keep interest rates higher for longer than everyone expected until recently, while European central banks will get on with loosening monetary policy. The reason is a seeming divergence between the latest inflation data but also differing accounts of what has driven price rises. So is US inflation from Mars and euro inflation from Venus? Like with the original geopolitical version, the shorthand is more cute than correct. The reality is complicated.

There is a widespread view that the US and Europe (by which I refer here to the countries using the euro) have had inflation experiences that diverge in ways requiring different policy responses. In particular, there is a tendency to blame US inflation on domestic fiscal policy excesses, while putting the Eurozone in the “unlucky negative energy shock” box. The implication is, to simplify only a little, that the US is doomed to live with higher-for-longer rates and some difficult fiscal choices, while the Eurozone is just damned whatever it does.

You need go no further than the IMF for support of the “different inflation drivers” story. As my colleague Martin Wolf set out in his column a few weeks ago, the fund’s World Economic Outlook attributed much of the US inflation rise to overheating labour markets, but none in the Eurozone. Below I, er, steal Martin’s chart, which itself reproduces the WEO’s:

According to the IMF, virtually all the US upward price pressures since inflation peaked come from a labour market that is “too” strong (the pink bars). In the Eurozone, it’s entirely a story of outside shocks and their propagation (shades of blue).

A simpler and more recent contrast that is often noted is between the behaviours of the standard gauges of inflation on the two sides of the Atlantic so far this year. On a month-to-month basis, inflation dynamics have moved the wrong way in the US recently, with prices now rising faster this year than over the past six or 12 months taken as a whole. It is this pick-up in US inflation measures that has pushed out previously expected Federal Reserve rate cuts beyond the immediate horizon. The European Central Bank, meanwhile, is sticking to plans for a June cut, with the justification that its targeted inflation rate remains quiescent — see the chart below. (Elsewhere in Europe, a loosening cycle is already under way. The Riksbank gave Swedish borrowers their first rate reduction this week.)

So far, so conventional. But as inflation nerds know, different countries use different inflation measures. If we want to compare like with like we need to use identical indicators. So take a look below, where I have charted the harmonised index of consumer prices, not seasonally adjusted, for both the US and the Eurozone. It’s the one normally reported for all Eurozone countries, and it happens to be available for the US as well. Moreover, it excludes a measure of housing costs that has recently been confounding observations of US price dynamics. (Here is the US Bureau of Labor Statistics’ page about how it produces the US HICP for international comparison purposes and how it differs from its homegrown indicators.)

If you see the same as I do, this like-for-like measure of inflation has behaved remarkably similarly in the latest episode, with just a slightly later onset of the rise in Europe compared with the US. Most importantly, the most recent inflation experience shows a clear pick-up in both economies.

This similarity could mean one of two things. Either US inflation dynamics are more benign than the other measures would seem to suggest and the Fed should be as willing to cut as the ECB. Or Eurozone ones should worry the ECB more than they do. I tend towards the first answer, since once you use the seasonally adjusted Eurozone numbers, disinflation seems to be going just fine. (In other words, the pick-up after January in the non-adjusted measure is just a recurring annual pattern.) I would feel even firmer in that belief if a seasonally adjusted version of US HICP showed the same as the Eurozone numbers. But I haven’t been able to find such version (Free Lunch readers, let me know if you have). Eyeballing the unadjusted US and Eurozone HICP over time, though, does seem to show similar annual fluctuations. So it’s a good guess seasonal adjustment would remove the recent US uptick.

But that doesn’t need to unsettle the bigger story of differential drivers of post-Covid inflation. Or does it? When I first saw the chart I reproduced at the start of this piece, what struck me was how a very similar chart had told a very different story. In February, Chris Giles devoted his excellent central banking newsletter to another project of decomposing the contributions to inflation since Covid-19. That included this wonderful chart:

What I would like you to focus on are the dark blue bars, which denote the contribution to price pressures from overheating labour markets. Compare the US and the Eurozone in this chart, then look back at the chart at the top of this piece. You got it: they tell completely different stories about the causes of inflation in the US in terms of how much labour markets drove up wages and prices.

The chart from Chris reproduces the findings of a project (see chapter 16 in the linked book) to extend to many countries the Bernanke-Blanchard analysis of US inflation that we covered in Free Lunch last year. Across the board, they found that: “The decompositions yield one main and common conclusion: most of the quarter-to-quarter movements in inflation have been due to price shocks, not to pressure from the labour market.” Mars and Venus turn out to be very similar planets.

What are we to conclude from this? Obviously, that there is less consensus than it might seem on the nature of the great global inflation and disinflation of the past three years. That in itself is worrying and should make policymakers even more aware of the uncertainty clouding their decisions.

Beyond that, can we establish who is more likely to be right, the “divergers” or the “convergers”? I certainly cannot as it would take a lot more fine-grained economic analysis than I can do here. And it could be that it’s impossible if (as Chris suggested in his piece) what the models produce is so sensitive to what assumptions you put in that even understanding why they differ leaves us none the wiser. I will, however, share one reason why I would put my money on the “converger” result of the Bernanke-Blanchard method for now. The IMF methodology (details here) seems to have used a different measure of labour market tightness for the Eurozone (where it used unemployment compared with trend) and the US (where it used vacancy rates). Bernanke-Blanchard used a consistent measure everywhere (vacancy rates). That alone makes me trust the latter more. But it also adds to the confusion, as you would have expected the US findings to be more similar between the two studies and not the Eurozone ones as is the case.

Finally, how would it matter if the “convergers” are right and the “divergers” wrong? Well, it would mean that diverging central bank policy means someone is making a mistake, which will cause trouble even if we don’t know who is making it. But I think it would mean something else, too. For the “convergers” converge on a result that labour market overheating played a negligible role everywhere. In which case, inflation was everywhere largely the result of an unavoidable global commodity price shock, with only minor local variations. And that makes me, at least, lean further towards the view I offered a while back, that there was never very much central banks could do about this inflationary episode — and that we err in blaming them for failing.

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