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Economy in Brief

Euro Area PPI Inflation Drops Sharply...or Does It?
by Robert Brusca January 7, 2009

Short term inflation: dropping like a feather in a vacuum
Like the HICP report the EMU PPI report shows a sharp ongoing drop in prices. Inflation has been cut sharply over short horizons. The headline (X construction) is dropping at an 11% annualized pace over three months and at a pace of -2.3% over six months. Yr/Yr the rate is still positive at 2.3%.

Short term Ex energy trends are solid
Ex energy inflation at the PPI level in November is at a -4.9% rate over 3-mos, a -0.2% pace over 6-mos and at +2.3% over 12-mos. The trending is the same: over shorter horizons the pace of decline is more severe. This is what confirms that inflation is still decelerating and has not yet stopped decelerating. In November both total and ex energy inflation fell sharply month-to-month.

However…
For those who want to be more cautious, or even fearful of what may lie in store over longer periods, the Yr/Yr charts are telling a different story.

For the PPI inflation’s TREND is still…RISING
The chart shows that inflation viewed over long spans of time also has cycles and the various sectors show there has been some inflation percolating, cycling around an upward trend going back to the sector lows around 1999. For ex energy inflation (not pictured) the low dates from early 2002.

Inflation has cycles
Let’s use intermediate goods as the baseline example since its cycles are clear. It has local inflation cycle peaks in 2000, 2003, 2004, 2006 and lower ‘peak’ in 2008. Other sectors have approximately the same cycles with varying amplitudes. But for each sector the same thing is true: the underlying trend for INFLATION has been rising as the various cycles have gone through their respective boom-bust phases. So the essential question is whether policy should look at where we are in this inflation cycle or to be more worried about the underlying rising inflation trend?

Identifying the trend
If you imagine a line touching the lowest point in each inflation cycle for each sector you will note that intermediate goods inflation is now below its lower cycle trend line (that slopes up) but that has only just happened. Consumer goods inflation at the PPI level is still above its trend (similarly constructed), so despite its current plunge, the long term trend of consumer goods inflation acceleration is still in play. Capital goods prices are still on the rise and inflation has really not fallen significantly yr/yr for capital goods. Taking ex energy inflation as an extra category (but not pictured) we find that that series is below its cycle low point trend line in 2008, but that is a very new development. It could signal that the long term inflation uptrend is really is getting broken. But, of course, the inflation dynamic is created in tandem with the growth dynamic so policymakers need to keep the whole picture in mind to decide. By the way, with fewer cycles to contend with it is clear that this same logic applies to the EMU HICP rate through December. Its inflation reading is falling rapidly but clearly has only just dropped below its ceiling. History is replete with spikes down in inflation that did not last. What is the ECB to do?

What went wrong?
If there is one thing this cycle has taught us it is to think outside the box – or at least to plan ahead and think broadly. The ECB’s backward looking Yr/Yr inflation ceiling did not serve it well to make policy in this cycle. It kept the bank too tight for too long. Only the financial crises with the ECB rate cut masked as part of a global effort allowed it to bring rates lower with inflation still well above its ‘ceiling.’ Inflation continued its rise in its headline even as energy prices broke lower; it took an unprecedented crash in oil prices to bring the headline back into the required zone (this references HICP inflation).

Lessons from the brink and over the edge
The point we keep coming back to in this regard is that decisions on interest rates need to be broader than just to look at a headline price series- even if containing that series is the ultimate policy goal. The Fed’s policy of looking at core inflation served it much better in the cycle and provided a solid basis from which to engineer that global coordinated rate cut that kicked things off while the ECB’s headline inflation series was still well above its ‘ceiling’. The ECB would be well advised to seek a more stable target for its policy focus or it will again find itself behind the policy and credibility eight-ball.

The policy dilemma
Looking ahead the ECB has a different sort of decision to make. As we can see short term inflation is cycling lower, but on a longer term perspective inflation trends do not look so unambiguously good. What’s the ECB to do? On the basis of Yr/Yr inflation despite the very rapid plunge in prices it is possible to continue to hear calls of caution (from places like…Germany?) about the need to cut interest rates. Yet the economy is weakening and the plunge in short term inflation seems to be another signal about much weakness is cumulating. The ECB probably will cut rates again but I expect there to be some reluctance as Europe has not grasped the magnitude of this financial crises and economic slowdown from the start. I don’t expect it to become a believer now even though it finally agreed to take more aggressive steps on the fiscal and monetary side. Call it euro-reluctance, or something else, but it’s there and it is resistant to the very idea of stimulus of any sort.


Euro Area and UK PPI Trends
  M/M Saar
Euro Area 15 Oct-08 Sep-08 3-Mo 6-Mo Yr/Yr Y/Y Yr Ago
Total excl Constructions -0.8% -0.3% -5.8% 4.1% 6.3% 3.3%
Excl Energy -0.4% 0.0% -1.0% 2.0% 3.2% 3.2%
Capital Goods 0.0% 0.1% 1.2% 2.0% 2.2% 1.5%
Consumer Goods -0.1% -0.1% -0.1% 1.0% 2.6% 3.4%
Intermediate & Capital Goods -0.6% 0.0% -1.6% 2.5% 3.6% 3.0%
Energy -2.0% -1.0% -18.9% 9.9% 15.8% 4.3%
MFG -1.5% -0.5% -9.9% 0.1% 3.5% 3.9%
Germany 0.0% 0.3% -1.2% 7.3% 7.8% 1.7%
Excl Energy -0.3% 0.1% 0.0% 2.7% 2.9% 2.4%
Italy -1.5% -0.5% -7.7% 2.0% 5.2% 3.7%
Excl Energy -0.7% -0.1% -2.3% 0.8% 3.0% 3.2%
UK -4.2% -1.0% -26.7% -0.8% 11.4% 5.9%
Excl Energy -0.5% 0.3% -0.7% 5.6% 7.0% 3.8%
Euro Area 15 Harmonized PPI excluding Construction
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