William De Vijlder

Euro area headline inflation has been in negative territory for several months and core inflation is stuck at a very low level. Unemployment is expected to rise further before starting to decline, so wage increases should remain limited. Does this mean that inflation is bound to remain low for a long time? Not necessarily.

The preliminary estimation for euro area inflation surprised to the upside, with annual core inflation reaching 1.4% in January. Monthly inflation was negative however, at -0.5%. Due to the Covid-19 pandemic, inflation data have become very noisy and hence more difficult to interpret. Survey data show rising input prices and lengthening of delivery times, which could exert some upward pressure on inflation. These factors should dissipate during the course of the year. Given the economic slack, any lasting pick-up in inflation should be a very gradual process

With the pace of vaccination roll-out, new infections in many countries and the emergence of variants, there is a risk that restrictions may need to be kept in place. This would induce a delay in the recovery. In the sectors impacted by the restrictions, the difficult times would last longer and could lead to bigger damage. Finally, an international comparison of the recovery pace could have an impact on capital flows and the euro, given that the eurozone is lagging behind.

The introduction of vaccines will enable the global economy to make the shift from a stuttering recovery, shaped by a series of lockdowns and their relaxations, towards a steadier growth trend. A key factor will be the gradual reduction in uncertainty, which will encourage households to spend and businesses to invest. The quicker we reach collective immunity, the stronger this economic momentum will be.

Narratives –the stories people tell about events- may influence behaviour. In future years, several narratives may very well be used when looking back at economic developments in 2020. Big, unanticipated shocks do happen. In terms of monetary policy, a ‘whatever it takes’ attitude prevails. This also applies increasingly to fiscal policy. In terms of financial markets, the dominant attitude towards risky assets is to buy rather than to say ‘bye bye’. With Next Generation EU, the European Union has again demonstrated that, under pressure, it can make big leaps forward. Finally, attention to sustainable growth has become ubiquitous. Some of these narratives provide comfort but several also come with a warning.

Until the very end, 2020 has been a difficult year, to say the least. However, there are reasons to be cautiously hopeful about the economy in 2021. Vaccination should reduce the uncertainty about the economic outlook. Ongoing fiscal and monetary support is also important. However, more than ever, caution is necessary in making forecasts. Reaching herd immunity may take longer than expected and some of the economic consequences of the pandemic may only manifest themselves over time.

Covid-19 represents an exogenous shock to the global economy of unseen proportions in recent decades. The reaction has been swift and agile. Central banks have eased policy and injected liquidity whereas governments have put fiscal discipline aside and used their budgets to bring much-needed support. This has softened the blow from the pandemic. What has also played a role is the agility of companies by adapting their production and/or distribution models to cope with the disruption of supply chains and the impact of restrictions on sales and by making it possible for a lot of their staff to work from home. Most importantly, the development of a vaccine brings hope at the end of a very difficult and challenging year. Vaccination should lead to a lasting economic recovery although questions remain about the possible longer-lasting impact of the pandemic in terms of unemployment and corporate as well as public sector indebtedness.

The prospect of the deployment of a Covid-19 vaccine has raised expectations that the stop-start cycle seen this year will make way for a lasting economic recovery in 2021. There is concern however that bringing the pandemic under control could take more time than is currently assumed in economic projections. Under such a scenario, worries about possible new restrictions would remain elevated, although one can assume that, because of vaccination, these measures would be less strict than before and more local.Nevertheless, in the more exposed sectors, investment and employment could be clear victims.

The Covid-19 pandemic has caused a decline in inflation and, in most euro area countries, an increase in the inflation dispersion between sectors. It will take considerable time until activity has been restored sufficiently to generate labour market bottlenecks, which –in the absence of exogenous shocks- are a necessary condition to see a broad-based and lasting increase in inflation. This suggests that for the coming years, we should expect inflation to fluctuate around a slowly rising trend. In the course of 2021, the unleashing of pent-up demand –under the assumption that a vaccine is sufficiently widely deployed- could cause a temporary pick-up in inflation. In this respect, a decline in the price elasticity of demand will play a key role.

The announcement that a Covid-19 vaccine that is under development is highly effective caused major reactions in financial markets, reflecting a feeling that the growth outlook has changed. The prospect of a vaccine offers hope that in the medium run activity will normalise, but the positive impact on growth will take time to materialise. Clearly, the view that better times are ahead of us very much depends on the horizon one takes. However, decisions of households and businesses not only depend on expected growth of income and profits but also on the distribution around the growth forecast. The prospect of a vaccine reduces the probability of very negative outcomes and this reduction in uncertainty should eventually contribute to a pick-up in growth.

After a mechanical and spectacular recovery in economic activity during the third quarter, there seems to be a real risk that the euro zone will see the recovery come to an abrupt halt in the final quarter of the year. This will be due to the sharp rise in the number of new coronavirus cases, the measures taken to restrict the spread of the disease and the general feeling of uncertainty that will hold back spending. This said, we can already look forward to the impetus to recovery from a relaxation of these measures once the number of new cases has been brought back under control. We are therefore living in a stop-start economy, with strong acceleration alternating with brutal slowdowns. Such an environment, with its lack of visibility beyond the short term, is depressing the propensity of businesses to invest. Households may also delay spending on large-ticket items. Monetary and, to an even greater extent, fiscal support will thus remain crucial. Spillover effects from the rest of the world will also play a key role. In this context, one thinks of China and of the USA, where a new stimulus package is being drawn up.