The Pitfalls of the Inflation Blame Game

• We fail to see the upside for the ECB in focusing on profit margins as a key factor behind inflation persistence
• Deposit migration is a normal feature – but non-banks cannot take up all the “funding slack” left by banks.

Core inflation accelerated again in March in the Euro area, while the decline energy prices, which is helping to push headline inflation down, could be jeopardized by the latest supply cut announced over the weekend by OPEC. The ECB’s frustration is understandable, but we are concerned by their focus on resilient profit margins as the main factor behind inflation persistence. Such line of communication could strengthen the position of those who argue for a very large catch-up in wages. This would weaken the ECB’s message of caution to the stakeholders in the wage bargaining process. More fundamentally, we fail to see the upside for the central bank in insisting on corporate pricing behaviour, which, unlike wage bargaining, is completely decentralized. While unions may internalize in their reaction function the adverse consequences for job creation that large interest rate hikes would have if wages accelerated too much, there is no organized “pricing coordination” system in the corporate sector – nor should there be, as per the EU’s very own pro-competition stance. Where there is no obstacle to competition, excess profit margins usually reflect lingering pockets of excess demand – otherwise, by construction firms could not sustain higher markups. It’s up to the central bank to determine whether more hikes are needed to deal with these pockets.

Market indicators suggest some measure of calm has come back in the banking industry, and the Fed’s latest data show that small banks stopped losing deposits. However, the deposit base continues to erode in the aggregate US banking sector. We look at the last 40 years to show that deposit migrations towards non-banks – or at least towards more expensive resources for banks - are not exceptional but are a regular reaction to monetary tightening. We however cast a doubt at the idea that non-banks could take up all the “credit slack” left by banks. Risks aversion is rife, and disintermediated funding may favour governments over private actors, as the recent developments in US money market funds suggest.