FRANKFURT (Reuters) - A weakening link between prices and growth could make it more costly and difficult for central banks to control inflation, leaving policymakers with a serious problem, European Central Bank Vice President Vitor Constancio said on Friday.
New research also shows that exchange rate fluctuations may have a smaller impact on prices than in the past, suggesting that the euro’s recent rally could be a more modest drag on prices than now expected, Constancio said in a largely academic speech.
With major economies enjoying a relatively long period of healthy expansion, policymakers have been puzzled by paltry wage growth, which has kept a lid on inflation and force central banks to provide stimulus much longer than they expected.
Indeed, having already bought over 2 trillion euros’ worth of bonds to depress borrowing costs, the ECB will debate next month whether to curb stimulus given 17 consecutive quarters of growth, accepting that is will simply take longer to raise inflation.
“The apparent disconnect between inflation and economic slack seems to have made interpreting and controlling inflation dynamics more difficult, with significant consequences for the conduct of monetary policy,” Constancio said at a conference.
“From a policymaker’s perspective, such an apparent breakdown is serious,” he said, arguing that fighting high inflation would have a bigger drag on the real economy, while a fight against low inflation would test the limits of policy tools, given the massive stimulus required.
In challenging another accepted relationship - that between exchange rates and inflation - Constancio said that fresh research also showed a weakening link.
“This insight is especially relevant for the euro area, as it suggests that the recent euro appreciation may have a more limited dampening effect on inflation than what would be implied by historical averages,” Constancio said.
With the euro EUR= up almost 14 percent against the euro this year, the ECB this month cut some of its inflation projections, arguing that the currency would weigh on the price of imported goods, keeping price growth down.
Reporting by Balazs Koranyi; Editing by Robin Pomeroy