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Economy in Brief

German PPI Flares; Largest Rise Since 1975 – Is It Really a Mirage?
by Robert Brusca  August 20, 2021

The German PPI rose by a brisk 1.9% in July as the PPI excluding energy gained 1.2%. June also saw a better-than one percentage point gain in both the PPI and the ex-energy PPI as did May. In fact, March and April both come close to these marks with month-to-month gains of 0.8% and 0.9% for the headline and ex-energy measures, both. Inflation pressures have become intense and are lasting. There is a 'nice' string of price strength here in Germany that may not transmit to the CPI and may not become a problem for monetary policy. Or, then again, it might…

For now we are speculating and we will have to wait to see how things shake out in the 'real world.'

What is clear is that German PPI inflation really is too high and it is accelerating from 12-months to six-months to three-months. The same is true for the CPI and the CPI excluding energy also is too high and it is accelerating from 12-months to six-months to three-months. There is a whole lot of uncomfortable inflation news here. And Germany is not alone in this. It is, more or less, a global phenomenon.

PPI strength is off the map and is showing the strongest 12-month gain since 1975. That's the strongest gain in 44 years. It marks a prodigious benchmark gain. As the chart shows, acceleration is still in train. And by the way, those lines on the chart are not Elon Musk's rocket being chased by Jeff Bezos's and Richard Branson's rockets.

The small table shows that the PPI and PPI excluding energy both correlate on a price-level to price-level basis at about 0.6 to Brent. Expressed as 12-month changes, the correlation between the PPI headline and Brent drops to 0.42 and for the ex-energy PPI it actually ticks slightly higher holding to the 0.6 correlation level. The CPI price level correlation to Brent is lower than the PPI at 0.32 for the headline and 0.55 for the ex-energy measure. These correlations melt away significantly when we execute them on 12-month percentage changes. On that basis, the headline CPI to Brent changes correlated at a 0.21 level and the ex-energy CPI-to-Brent correlation drops to a -0.1.

This correlation sequence is the basis for thinking that the PPI has substantially elevated because of the strength in Brent oil prices but that the CPI will not be as affected and may not be affected at all.

However, that is a sort of head-in-the-sand approach that assumes that the PPI is reacting primarily to Brent. As we know there are a lot of price pressures in flux across a broad swath of products and for commodities as well. Globally supply chain issues have interrupted the flow of commerce and the ease-of-access to output and the product of cheap labor from anywhere in the world- as used to be the case - has been severed or greatly impaired. If the cost of the cheapest labor in China or Vietnam were once the global marginal cost, that is the case no more. How long this new situation will last is anyone's guess.

Quite beyond positing that, like in the game of Clue, the deed was done by Brent prices in the solarium by means of rising oil prices it is possible that there is more than one culprit here. More broadly we find the core PPI and core CPI prices on a 12-month percentage change basis are correlated at a lowly 0.14 mark and that headline to headline the PPI and CPI are correlated at 0.69, a much higher mark.

However, over the last two years the PPI and CPI headline and core correlations have been higher at 0.79 for the headlines and 0.56 for the core.

As always correlations tell you something but not always what you think. 'A' may correlate to 'B' because there is some A → B causal link or it may be because both 'A' and 'B' are correlated to a third variable as we explored above with oil prices. But oil prices are not the only potential suitor for such a relationship. In our situation, it is likely that the impact of 'the Virus' on economic activity pushed many of the same effects onto both CPI and PPI prices raising the correlation for this period. In fact, correlations for the year-on-year percentage changes of the CPI and PPI headlines and their respective ex-energy readings are both above 0.9; they are at 0.97 for the two headlines.

These circumstances make it hard for us to know what happens next. Central bankers have stuck their necks out to call these price pressures temporary or transitory. But in fact, we know that under the surface there have been some more permanent changes, a situation that would make us all a bit more skeptical in declaring that 'we know.' But central bankers imbue their view with a sense of certainty that I think is simply unfounded. Perhaps they think that if we believe what that they know is true we will shift our beliefs…

In time we will sort this out and discover 'truth.' I hope it is of a nature that we are not harmed by it before we discover what it is. But we cannot be sure of that. For now, what we can see is that inflation pressures are cooking across timelines and across inflation measures. In the U.S., in its recent minutes the Fed's FOMC members discuss price trends and refer to them as concentrated in a few products or industries. But when I run statistical screens all the CPI components, I get results that see inflation at or above 2% is a very broad way. Inflation at or about 2.5% is less broad way but still a dominant trait for over 60% of the CPI items. Inflation is above 3% in more than half of the CPI categories, to boot. That is not a small or isolated group. And 3% inflation over 12 months is not low inflation when the target is 2% even on 'average.' Moreover, inflation expectations in the U.S. are up and the statistical 'mean' in the U of M survey for inflation five-years ahead is at 3.8% - last higher over 12-years ago; yet, the Fed calls inflation expectations 'in sync' with its target. Really! Over 3.5% for five-years in the future and that is OK?

So I wonder exactly how central bankers are coming to support views that I do not seem to be able to identify on my own. Pardon me If I remain suspicious of the Fed's constant denial of inflation reality and if I focus on its 'forecasts' from 2015-2018 when it led us astray. By thinking – AGAIN- that current inflation reality is wrong and its forecast is right, the Fed is once again substituting a view of reality for reality. It is once again doing the same thing, finding a distraction from current reality to dismiss what is a perfectly valid and entrenched inflation trend in order to ignore it. For European and German conditions, things are not as distorted as in the U.S. But the denial is still there. Central bankers playing 'let's pretend' is always dangerous. It's more like Russian roulette with no empty chambers- best not to go there at all. Stick with what you know to be true. Hedge-bet your hypothesis; do not put all your chips in the middle on a guess. Be wary of dismissing a reality that is uncomfortable. But that is not the current policy gambit so we all are at risk and can only hope that central bankers will play a strong end game if the gambit goes poorly.

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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