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Economy in Brief

EMU Inflation Remains Astonishingly Muted; What Does That Tell Us?
by Robert Brusca  May 3, 2018

The chart tells the tortured story of recent EMU inflation trends. Inflation remained low in the wake of the financial crisis and then the EMU area transitioned into a period with sporadic deflation. After mid 2016 it broke away from the deflation risk and inflation ran up relatively briskly. There were complaints from Germany and other ‘hard-money’ members in the EMU that the ECB was not reacting fast enough to rising and potential inflation pressures. But in early 2017, worldwide and EMU pressures shifted again and did so sharply. Inflation receded from its peak. And then it began to stabilize and increase more slowly. Now in early 2018, we are trying to figure out where we are in this convoluted price-trend process. Is inflation still stabilizing or is it eroding?

ECB Chief Economist Peter Praet told us just today that the ECB is making substantial progress in lifting inflation. But the HICP is up by only 1.3% year-on-year and the core is up by 1.1% year-on-year. It seems to me that Praet is trying to put lipstick on a pig. Praet’s quote on the subject is simply this:
“We cannot yet declare ‘mission accomplished’ on the inflation front, but we have made substantial progress on the path towards a sustained adjustment in inflation" (Source here).

As we saw in yesterday’s news, GDP in the euro area slowed in Q1. Today a new set of forecasts from the EU Commission has kept the outlook for the EMU unchanged for the next two years but has flagged a higher risk factor. There has been a global slowing in progress. GDP by all the early reporters (see yesterday’s research report) showed decelerations were everywhere except in the U.S. on year-on-year growth rates. Clearly the central banks are not out of the woods, the economies are not out of the woods and some policymakers seem to be lost in the woods (not to be confused with the new Netflix series Lost in Space).

It is interesting to juxtapose the European situation to that of the U.S. where, after a central bank meeting just yesterday, the Fed appears to have a clear path and few obstacles in its way on the way to higher interest rate levels. The Fed is now hitting or all-but-hitting its inflation objective (the headline PCE is there but the core is still ‘a tick’ short).

Globally, unemployment is extremely low, with similar developments in the U.S., Germany the U.K. and Japan to name a few. But is U.S. inflation clearly on an upswing? Is EMU inflation falling or stable? How can the U.S. build inflation pressures if Europe is not? And if the dollar is on an upward path, can U.S. inflation rise very much? Has the Fed begun to count its chickens before they are hatched?

The U.S. inflation trend’s return to target has been long awaited and now it is embraced with little skepticism. Europe’s inflation trends are not clear. In Europe, core inflation, the more stable series, is at 1.1% over 12 months; it then ticks up to a 1.3% pace over six months and three months. Looking at the country level data inflation in Germany, France, Italy and Spain, inflation rises in six months above the 12-month pace then declines over three months from the six-month pace. And except for Germany, the pace of inflation over three months is lower in each of these countries than the pace over 12 months. That is also true of the overall EMU inflation rate but not true for the EMU core.

The turn lower for EMU inflation was a surprise. And the slowing in Europe and in the global economy also has been unexpected. The U.S. is showing signs of a slowing as well as is PMI gauges have receded; the nonmanufacturing ISM just today moved lower in April. The U.S. consumer has been a major disappointment. It is not at atmosphere for optimism. While the U.S. data are not as questioning as the data of Europe, one of the most perplexing and in its own way disturbing signs is the sharp drop in U.S. imports logged in today’s trade report. Imports come in to satisfy domestic demand; and if this demand is weakening, imports weaken or drop since they are more volatile than demand itself. If that is the message, it is a bad sign. The arithmetic effect of lower imports is to boost GDP. So that calculation is confusing as it is going to send GDP in one direction and perhaps signal that trends are heading in the other direction. The U.S. paradigm seems to be up for grabs and that is in train just as the inflation picture offered the promise of being resolved.

Growth and inflation trends globally have hit an air pocket and we are waiting to see where things will settle down. For my tastes, it is too soon for the Fed to declare inflation victory. It was careful not to do at its recent meeting. But the ECB seems to be too defensive and too eager to try to shore up confidence that it has inflation on the right path. Central banks have learned in this cycle the importance of managing market expectations. I view the ECB’s Praet’s remarks in that perspective. His mouth may be the ECB’s most effective weapon. Still, talking alone cannot make it so. But the ECB definitely wants to avoid any backsliding. Yet, it has few tools at its disposal and none that it wants to use. If the Federal Reserve has little room to move should conditions deteriorate the ECB has even less. We have moved into an uncomfortable waiting game surrounded by economic uncertainty and enveloped in geopolitical chaos. I feel like a kid again sitting with trepidation in the waiting room of my dentist, not knowing what lies ahead but sure that it will be painful.

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