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Economy in Brief

German Prices Rise Sharply; Fastest Year-on-Year Rise in 27 Years
by Robert Brusca  August 11, 2021

The chart is clear and the calculation is unequivocal. But what it means is something else.

The CPI gain is extremely large reported as the largest year-on-year rise in 27 years. But that gain is/was enhanced, but the extreme weakness in prices one year ago as Covid struck creating economic chaos.

As Germany faces a spurt in inflation that is well beyond any recent historic experience, the U.S. has released its CPI today and the gain stepped down from its extreme rise of one month-ago rising by ‘only’ 0.5% month-to-month instead of 0.9% in the month.

Central bankers have been emphasizing that the spike and pressure exhibited by inflation will be temporary. U.S. markets are reacting well to the notion of a deceleration while Germany is still in the throes of accelerating inflation. Markets in the U.S. are reacting well to the step down in U.S. inflation and the drop in the annualized monthly pace from 11% to 6%. That is progress, but 6% inflation still is not good.

In a similar vein, European markets are not embracing the spiking German inflation rate as real but are treating it a something that will be a passing phenomenon. Central bankers are selling their Kool Aid on street corners and everyone is drinking it. Looking back at inflation, there is nothing in its recent history to suggest that any such acceleration should be in progress. Clearly part of what we are seeing is related to the short-lived move to disinflation of one year ago that is now unwinding. Another part is due to the pandemic and some temporary bottleneck issues that have arisen… but is there another, more permanent, aspect to the inflation rise as well? Central bankers seem to deny this and yet the events of the last year and one-half are nothing if not inflationary.

Money supply growth has soared, government support payments have risen. Government debt levels are elevated. And firms have begun doing something they have not done in a long while; they are raising prices. And wages are rising too. But inflation is still generally out ahead of wage gains setting the stage perhaps for some old uncomfortable labor market dynamics involving wages and prices. These are global conditions that are more extreme in some places compared to others.

Germany is traditionally a low inflation country. Following an experience with post-war hyperinflation, Germany re-set its central bank as an independent institution and gave it one job to control inflation. Today’s ECB is modeled on the former Bundesbank structure, but even now the ECB has adopted a change that will make higher inflation more tolerable as the bank shoots for an average of 2% inflation instead of keeping inflation below 2%. What this will mean for the period ahead we have yet to discover. It is not the change per se that is important as much as the way the policy will be administered since 2% is a harder number than you might think; ‘less than 2%’ is a clear result. But ‘average’ is a statistic and it really has no precise meaning. The average you get depends on the period you choose to calculate it. So average inflation is not the same rock-hard target as ‘less than 2% even though it is less than 2% that sounds vaguer.

Modern economic theory points to the role of expectations in keeping inflation in check. In the past, there was more of an emphasis on wage market developments and the potential for wage-price spirals. The emphasis has shifted to looking at wage and price expectations. But expectations do not predict future inflation very well. There is much more to the picture than that.

What I am worried about is behavior. The problem with expectations is that everyone has them but they are not always strongly enough held to govern behavior. So behavior is the key, not expectations. And the problem is that allowing prices to rise, changes the game from what it has been over the past decade in which firms felt they could not change prices. Not being able to raise prices made firms more reluctant to raise wages. These perceptions and this behavior kept inflation in check more than any expectations did. So now the post-Covid inflation rise changes the game by changing behavior. We have let the genie out of the bottle; opened Pandora’s Box and there is no telling how much this will change the future. But behavior is already changed. And new lessons are being learned. And expectations for inflation are askew and they are rising as well.

Inflation diffusion is high too. In Germany, year-over-year inflation is higher than it was a year ago in about 80% of the CPI categories. Over six months with headline inflation at 4% and core at 3%, inflation diffusion is 0.54 indicating that inflation is rising in 54% of the categories. That proportion is not so high, but the underlying pace of 4% or 3% for the core is high. Clearly even at that pace inflation is not decelerating. Over three months, headline inflation is at 4.5% and 3.7% in the core. And diffusion is back up to 63.6%- rising in nearly two-thirds of the categories.

The German CPI and core both show acceleration from 12 months to six months to three months. The HICP in contrast decelerates from 12-months to six-months then accelerates to a pace of 2.6% over three months from 1.5% over six months. Both the HICP total and core inflation rates for three months are higher than their 12-month counterparts while for the CPI the reverse is true.

These observations suggest that inflation is still not settled into a consistent track. It is accelerating inconsistently and even decelerating in some areas and on some timelines. It is too early to draw conclusions on what inflation is and what it will do. But if central bankers continue to set a passive course of action, that too will be reflected in people’s expectations and eventually in their behavior.

Of course, two loose ends remain loose. The virus is still distorting economic activity and oil prices are still high with an uncertain future. the future path for inflation remains elusive to everyone except central bankers.

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