The more euro-area economies engage in so-called structural reforms, the harder it may become for the European Central Bank to hit its inflation target.
It’s a counter-intuitive thought. After all, more competitive and more open economies should grow faster and so produce higher inflation. That’s why ECB officials – despairing of constantly pumping monetary stimulus into the financial system – are urging more reform.
That may all still be true, but there’s something else steering in the opposite direction, and it’s relevant to the 10 percent unemployment rate that still exists 7 years after the Great Recession.
Think of there being two unemployment rates. The first is the actual rate, more than 11 percent in Italy, 10 percent in France, 6 percent in Germany and so on. And then there’s the rate of unemployment at which inflation starts to accelerate as labor shortages push up wages, which feeds into prices. That’s known as NAIRU, and in most euro-area countries, it’s well below current rates.
Here’s the evidence, presented here using data analyzed by Bloomberg Intelligence’s Maxime Sbaihi.
Nairu isn’t set for all eternity. It changes depending on how flexible and how efficient the labor market is. If the rate is high, inflation could start to rise even while a large number of people are unable to find work. If it’s low, wages and prices may only start to climb once the economy approaches full employment.
When a country takes steps to make its labor market more efficient – as France and Italy have been trying to do since the crisis – NAIRU should fall. It takes time though. Reforms made in Germany in the mid 2000s are still being felt.
Policy makers see reforms that lead to more efficient labor markets as a good thing – after all, they help people get back to work. But there’s a side effect to a falling NAIRU.
“That means a longer path before you will see the build up of inflationary pressures in the labor market,” Sbaihi says.
In Germany right now, the actual rate of unemployment is very close to the NAIRU. But in France and Italy, there’s still a gap, and the NAIRU isn’t even falling yet.
Of course, there are other factors affecting inflation, like energy prices, so the reform effect shouldn’t be overestimated. But ECB officials pursuing both a return to their 2-percent inflation target and a reformed euro-area labor market, have already worried out loud about this issue. It’s conceivable they may be able to realize faster inflation or faster reform, but maybe not both at the same time.