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Global Inflation: a conversation with Michel Martinez, Chief Euro Economist at Societe Generale Corporate & Investment Banking

17 August 2015
Giada Vercelli

When Christian Noyer, the Governor of Banque de France delivered his opening address at the Euromoney Global Inflation Conference in Paris, he encouraged the select audience of asset managers, hedge funds and central banks to leverage the opportunities created by unprecedented market conditions, but he also urged them to assess the risks. The President of the European Central Bank, Mario Draghi had just warned that policy-makers should not allow aggressive monetary policy to blind them to the risks of financial instability. Central banks around the world have faced criticism that their response to the financial crisis has stoked asset-price bubbles and increased inequality. Both issuers of inflation-linked bonds and their investors aimed to identify alternative ways to generate a real return, but mainly all intended to shed light on some fundamental questions, to clarify the correlation between QE and inflation. Michel Martinez, Chief Euro Economist at Societe Generale Corporate & Investment Banking shared his views with Euromoney Conferences’ Giada Vercelli.

Euromoney Conferences: Looking at expectations of increased inflation, given this year's volatility in the bond market, do you think they are well-founded or surprisingly high? As for the recovery, what will be the drivers of a return toward the 2% inflation threshold?

Michel Martinez: Thanks to base effects from oil prices in euro terms, inflation has recently come back into positive territory and is likely to reach the 2.0% threshold at the turn of the year. This has probably had a large impact on market participants. Combined with the impact of QE purchases of inflation-linked bonds, inflation expectations have increased sharply, particularly medium-term expectations (2y2y), and have come back to levels we have not seen since last summer (from 1.0% to 1.2%). This is clearly the result of both the lower euro (thanks to QE) and the increase in oil prices. Today, the deflation scenario seems to have been avoided, barring any major external shock (China hard landing, bond crash...) Yet, this increase in inflation expectations has been big, a surprise for me also. I think it is largely driven by external factors (euro, oil) whereas core prices do not show any sign of quickening. As for the recovery, the return toward the 2% inflation threshold is conditioned upon: 1) a full implementation of QE; and 2) economic policies that can boost potential growth (growth-friendly fiscal policies including investment plans and structural reforms).

EC: Michel, on the back of what we have discussed and barring any major change in the oil price, do you have good reason to believe that core inflation will remain well below the 2% target for a while?

MM: Barring any major change in the oil price or the currency outlook, headline inflation should eventually converge to core inflation in the medium term. So the focus should be on core inflation which remains weak (0.6%). There are good reasons to believe that it will be hard for core inflation to get back to 2.0% in the medium term:

1) The output gap and the unemployment rate remain high. Most economists forecast a growth rate (1.5-2.0%) higher than potential (1.0%) for the next three years. But it will not be strong enough to fill the output gap quickly (SG view: not before 2019). History and the US example suggest that it is only when the employment gap is closed that wage pressures start rising (the Phillips curve is asymmetric - inelastic when the employment gap is large, elastic when the gap is closed). Germany is the only country in the euro area where this gap is going to be filled.

2) The wage bargaining process has been decentralized or is not indexed on inflation anymore. Given the very high unemployment rates, wage growth will remain much more muted than during past recoveries.

3) Most structural reforms (deregulation boosting competition, labour market reforms) have a negative impact on prices in the medium term. If euro area countries continue to implement structural reforms, price levels will continue to adjust to the downside. Examples: telecommunications (free in France, future abolition of roaming costs), and labour market reform in Spain. Policy makers sometime argue that this can be offset by a confidence shock that boosts growth (and as a result closes the output gap more quickly). Perhaps, but what I see in the surveys is that the level of uncertainty remains high. Businesses and consumers are not convinced yet because most policies are piecemeal.

 EC: Where did the impact of QE mostly come from? Was the size of QE big enough to boost core inflation?

MM: The impact comes mostly through the FX channel. The size of current QE is not big enough to boost core price towards 2.0% in the medium term, it would require a programme twice as big. But there would be negative side effects as we have seen with negative bond yields, lack of liquidity...

EC: The Japanese experience of two decades of deflation has led Prime Minister Abe to be at odds with Central Bank Governor Kuroda, who agreed to a radical QE programme anticipating a tighter fiscal policy, which is not happening. What are the main takeaways of this experience?

MM: Europe is not Japan. The main difference for me is that the JPY appreciated by 40% between 1997 and 2000, after the Asian crisis. With already low inflation in 1997, the Asian crisis led Japan into deflation. For me the big deflationary risk could be a major external shock (China hard landing, emerging crisis) which would lead to a flight to quality and as a result of a strong appreciation of the major currencies, including the euro.

EC: What are your expectations for inflation in the periphery vs the core of the Eurozone?

MM: It is odd to see that inflation swaps see inflation as high in Spain as in Germany from 2020 to 2025 (between 1.5 and 2.0%). The labour markets are not the same. The rebalancing is not over. I would expect core >soft>peripheral (except for Ireland).

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