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Economy in Brief

European Inflation Continues Its Surge
by Robert Brusca  November 30, 2021

EMU inflation rose by 0.7% in November after rising by 0.7% in October. EMU inflation, already elevated over 12 months, accelerates from that that pace of 4.8% to a pace of 5.7% over six months and accelerates again to 6.6% over three months.

Among the four largest EMU economies, inflation is accelerating for each one with each starting the process with an excessive rate over 12 months that becomes progressively more excessive over shorter periods. Italy reports out core inflation earlier than the other large economies; for Germany we show the ex-energy measure. The core/ex-energy trends show excessive inflation for Germany over 12 months but not for core inflation in Italy. In Germany, ex-energy inflation slows over six months and again over three months but is still at an excessive rate over three months at a pace of 2.9%. In Italy, year-on year core inflation is up by only 1.5% that does ratchet up to 3.1% over six months then stays at 3.1% over three months.

These trends show interesting possibilities for underlaying dynamics. The excessive and broad trends seem to be dominated by their food and energy components if the German and Italian ex-energy and core trends transfer to the other large economies. Italy shows inflation as not excessive under the core measure while Germany with the highest headline inflation in the EMU among the largest economies shows an ex-energy result that is compared to Italy's core result over three months at around a 3% pace.

A 3% pace for inflation is also excessive if we use the three-month core/ex-energy pace as the new benchmark. It is 50% more that the baseline target although EMU policy now allows for inflation averaging to occur. Averaging can be useful for evading short-term hikes in rates for inflation that might be temporary. It also allows policy to swerve where a non-averaging process would require action; if inflation really were accelerating, a non-averaging policy would be forced to act early.

Table 1

One of the key questions for policy is whether central bank judgement is 'good' or not. The ECB legacy, of course, comes from the Bundesbank where a target of 2% prevailed and not much discretion was allowed. The successor ECB adopted much of the Bundesbank's framework with an eye to achieving the same continuous inflation success. The ECB at first shot for an inflation rate of just below 2%. But an overzealous pursuit of that goal and a neglect of what inflation far below 2% might do, eventually lessened EMU member willingness to continue to wear that straitjacket. Instead, after the Great Recession and some severe austerity measures countries were put through, the ECB wound up changing its objective to an average inflation rate of 2%. It has not operated under that new directive for very long (since July 2021).

On the surface, this may seem to be a minor change but in practice the Bundesbank had defended 2% vigorously and had raised rates anytime inflation went above 2% - even if the core was below (such as when oil prices flared). The ECB now has license not to do that. In addition, interest rates in the euro area are extremely low. So, with inflation at these heights, the traditional hard-money EMU members are unhappy. But with the inflation overshoot and Covid issues still in play, the ECB's current policy tilt remains in force. The ECB is not about to be bullied by a minority of hard money board members - at least not yet. But there is a clear schism in the EMU even though inflation has now been more or less equally tamed across the monetary union with the exception of the recent flare up which ironically has hit Germany the hardest.

Table 2 below takes the alarming statistics of Table 1 and recasts them in a framework calculating inflation averages. The 12-month average of year-on-year inflation in the EMU is now only 2.2%; it is 2.7% in Germany and 2.4% in Spain, and it is still 'in-bounds' at 1.8% in France and 1.6% in Italy. Were the ECB to look at a 2-year average inflation mostly behaves across the board, the same is true of 3-year or 4-year.

To help understand what inflation calculating is like using averages, I have also provided a 4-year calculation of inflation calculated using a discrete calculation. This calculation looks at four consecutive nonoverlapping 12-month periods. When inflation is calculated that way the inflation average is 1.8% when we take the four-year average of all 12-months inflation rates that inflation calculation is lower at 1.4%. 1.8% is close to target while 1.4% looks more like something that is too low. How one averages makes a difference…

Such is the problem of calculating inflation averages especially when the averaging process and period are not defined. Very clearly the inflation problem- whatever it is - is relatively new. However, based on the inflation data we traditionally have watched, the latest trends are chilling and interest rate levels in the EMU are well behind the curve.

Table 2

And then there is the complicated action of circulating Covid and the new variant, Omicron- a variant of mostly unknown characteristics, but with a few known attributes, make health officials quite wary.

Policy in Europe is now not in a good place. Europe is still being inundated with migrants. Belarus has been insidiously channeling migrants through its domain into the EU area. This is in retribution for the EU not accepting the result of the last Belarus election that retuned a long-serving strongman to power. There are migrants clamoring to get in from Afghanistan. Also, Europe is dependent on natural gas from Russia and right now it is having a challenging time building inventories for winter. And Russia has mounted tanks on the border of Ukraine. There are also conflict with China and there is Iran trying to reopen its nuclear talks with the West.

In short, on the policy front there is a lot in flux, and all these issues layer on top of a burgeoning inflation problem at a time that interest rates remain at record lows. While everyone is focusing on the incoming inflation data and trying to handicap it and determine its sustainability, there are also rising fears about omicron. But in fact, there is a lot more that a worrier could worry about. These are generally challenging times. The strains on the economy, on our past ways of life, and on our institutions, now are forces to face reflecting new and unexpected challenges that make policy decision that much more difficult.

In the case of Covid, WHO has been aggressive in trying to channel more vaccine to the developing world and has not been successful. With this new variant arising in South Africa, an under-vaccinated country, there is yet another aspect of decision-making that policymakers have tried to ignore or dismiss. Developed countries cannot promote booster shots at home and vaccination of developing nation populations at the same time. These are two goals in conflict and so far, policy has simply ignored the conflict. But if WHO is right, this could be a major mistake. Since variants, wherever they arise, threaten everyone, the question is who IS right? What is the science vs. what is the policy? And why doesn't science determine policy?

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