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Economy in Brief

Is EMU Inflation Too Hot?
by Robert Brusca  February 2, 2022

Table 1

Ahhh...so the title bothers you? Is it like asking if fire is too hot; or water too wet? Well, may be so but consider this:

Table 2

Hmmm... Does Table 2 put in some perspective? (Hint: What IS inflation? Too high at 3% over 12 months or too low at 1.6% over two years?)

Do you have a Table 1 or a Table 2 view of the world? Well, let's table that for now…

A world of trouble
Most of us live in a Table 1 world. But central bankers seem to live in a Table 2 world, and they keep the curtains shut. What is our target? Is it behind curtain number 1, 2, 3, 4 or more? We experience things in real time and may gain some perspective from the past, but we do not consider averages real. No American in the 1960s had an 'average' family with 2.5 children, I can assure you of that. Averages are summary statistics they are not reality. But the ECB (like the Federal Reserve in the U.S.) has adopted a 2% inflation target. It no longer has the 'Bundesbank-esque' 'a little less than 2%' target. So, the inflation target in Europe has been (1) raised, (2) mystified, and (3) hidden.

Ready! Aim! Where'd it go?
When a central bank shoots at a target and tells us that the target is 2%, that target is a real thing- we all know what 2% is. And if it shoots at a target that is a statistic, well we no longer know what it is. When the central bank's hard 2% target is transformed to the statistical concept of 'average' it instantly becomes a different beast.

I do not know what I do not know
We may still 'know' that the central bank is shooting at 2%. But like the hunter in the woods who sees the bushes move and readies his rifle to shoot the eight-point buck he expects to spring forth…maybe he is wrong. Maybe that is just his wife bringing him some brownies while he is hunting? When the bushes move, and you can't see what is doing it, you do not know what to do. Like the hunter looking for the elusive 8-point buck, we are looking for the elusive 2% inflation. And UNLIKE the hunter who will eventually be able to see what is behind the bush: (1) a deer?, (2) a wild turkey?, (3) his wife?, (4) another hunter?, or (5) other? We never will. We never will because although we (much like the old U.S. supreme court) know 2% when we see it, since we do not know over which period to calculate our average, we really know next to nothing and despite all the CPI, HICP, PCE, or other data in the world we cannot know. As inspector Clouseau of Pink Panther fame used to say: …and I do not know what I do not know.

Opacity pawned off as transparency
When the central bank like the Fed or the ECB tells us it is targeting a statistic then refuses to give us the wherewithal to calculate that statistic it is targeting, that bank is hiding information from us. This is not a good turn of events. Any elementary school child can calculate a percentage but no trader on Wall Steet or in London, or Frankfurt or Tokyo - no matter what his/her IQ or how powerful the supporting computer- can calculate the central bank's inflation reference rate without MORE INFORMATION.

We are in the dark on this one.

Fed vs. ECB – it matters
So again, I ask, is inflation too hot…is it really? In the U.S., the CPI ended the year at a bone-chilling blood-pressure spiking 7%. Or at 5.8% in terms of the PCE index that the Fed targets (or 4.9% for the PCE-core). And with these numbers in hand, the Federal Reserve has suddenly reversed course and sprung to action. Its blasé approach of fiddle dee, its 'inflation is temporary' attitude has been transformed to one of action as the Fed is cancelling its taper, getting ready to hike rates three times in 2022 - at last look. But Street estimates put the Fed at 4 or 5 hikes in 2002! Now why do we care about U.S. inflation if we are talking about EMU inflation? There are some very similar inflation statistics in tow in Europe, and the ECB's Christine Lagarde has said that no policy moves are expected in 2022. That is Zero to 3 or perhaps Zero to five if you are keeping score. You see in the land of international policy you do not have 'good fences to be good neighbors.' What you have is the free flow of capital and flexible exchange rates to make sure that capital can flow across borders with alacrity of Omicron!

Transmissibility!
So, the ECB policy is going to be affected by the Fed and the Fed's policy is going to be affected by the ECB (a sort of monetary version of the Barney song!). When the Fed moved over to average inflation targeting and the ECB did likewise, it had looked as though U.S. and ECB policies would stay in sync. Sometimes economists worry of central banks having different targets or operating procedures that will have them operating in separate ways and create volatility. But, instead of being on the same page, the actual policy choices that are emerging seem to put the Fed and ECB on very different tracks. Once again…2% 'the average statistic' is not 2% the number.

Shot in the dark
In neither country do market participants really know what the central banks 'perceive' even though we know what they are looking at and what they are looking for. That may seem like one too many angels counted on the head of pin, but I assure you this is a matter of significant consequence as we see by looking at the ECB plan for the year ahead vs. the Fed plan.

Pretending to know the unknowable
Generals always say that a war plan is important but that all plans go out the window when the first shot is fired. And so, it may be too with central bank policies. The ECB may find its actual inflation or market reactions to its policies will not allow it to sit on its hands through December. The Fed may find that markets do not behave well once it starts hiking rates. Capital flows from abroad could flow in and stop long rates from rising; the dollar could be boosted (that could help drive inflation lower, faster…). The international linkages make for a number of possibilities on both sides. Policy changes could be prompted by events on either side of the Atlantic.

Having such different reaction functions (attitudes really, different interpretations of the same policy objective) in the U.S. and in the EMU will make 2022 an interesting time. And there will be blood and speculation.

One man's transparency is another man's flexibility
Central bankers COULD help limit the carnage by TELLING US what sort of average they are looking at. EMU 12-month headline inflation (using the flash) is 5%. The 12-month average is 'only' 3%. The two-year average is actually undershooting the target at 1.6%. If we know what the central bank is looking at to make policy decisions, we will be better prepared for the future. But if the central bank gives us a specific formula, it will limit its own flexibility. Even as bankers assure us how very transparent they are, they withhold this key piece of information that actually means the world to us and could help to resolve a deep statistical mystery. Is the ECB responding to an inflation rate of 3% or of 1.6% (one-year average vs. 2-year average)?

Revealed preference at work/transparency has handcuffs
Well based on the comments by ECB head Christine Lagarde, it seems to be the latter (or longer) not the former. But there is a hitch here. If a central bank told us, it was looking at an 18-month average of year-over-year inflation or a 24-month average or whatever- THAT would become the new standard and the bank would be 'stuck with it.' The problem is that, as the year goes on, if inflation just stays where it is-hypothetically, the averages will rise because we will add each month a high rate to the averaging process and drop a low rate. And so, the problem central bankers have in choosing a long average (to make current inflation look benign) is that eventually it will do the opposite and make inflation look worse even as inflation is beginning to fall in 'real time.' Both U.S. and ECB policy suffer this flaw.

Using both the imperial and the metric system -WITHOUT CONVERTING!
If central bankers DO NOT TELL US, their average they can play a game with it and look at a long average now and shorter average later (without telling us-SHhhh). But this is akin to having different rulers keeping a say 2-unit measure as your target but having one ruler expressed in inches, the other centimeters. Hey 2=2, right?

They have my cake and eat it too
So, pardon me is if suspect central banks of wanting to have MY cake and eat it too. Their jobs may be hard, but if it is too much for them, they can quit and let some else do it. We need clarity and transparency in monetary policy. Giving us an average 2% target especially in a time like this and not telling us the tenor is making monetary policy a game of hand grenades and horseshoes instead of one of precision. Markets will pay the price for this and eventually so will the central banks and so will the assessments of their credibility. It's one thing to have a judgmental policy; it's another thing to represent your policy as numerically hard when in fact it only scotch-taped to an undulating mold of Jell-O. It's not the same thing – at all.

Lagarde's dilemma -draw to an inside straight or face reality
Table 3 below presents the policy dilemma for the ECB. It is the absolutely BEST CASE possible with inflation suddenly ASSUMED to drop to a 0.2% gain per month in February of 2022 and to do that for the next 10 months in a row. Even with that the year-on-year inflation remains above 5% until June, and above 4% until October. It ends the year at 3.5%. (Because of all these wonderful assumptions in January of 2023 inflation would drop to 2.4% ) – that is of course not a result but an assumption, a result of MY assumption. The point of this is to show how long inflation is going to be excessive even in a best-case inflation world. And note that the 2-and 3-year averages of inflation are stubborn in fact inflation on a 3-year average will RISE from below 2% in early 2002 to 2.5% by yearend.

Table 3
A hypothetical experiment for the ECB

You can pay me now…or pay me later
So, this is the crux of the sneaky problem that becomes infused in policy when a long average is chosen for policy. A central bank can ignore the early stage of a policy mistake, but it will pay for that later. And if the bank is truly 'targeting this average' it should not have the same leeway to ignore it or to say 2.5% is close to 2% since as an average 2.5% is a long way from 2% - even though that logic might hold for a monthly annualized result – it does not hold for averages. We have yet to see how bankers will refer to averages when making policy. They will probably not be specific enough for us to be able to identify the average they are using. And remember, of course, that the actual numbers for 2022 are going to look much, much, worse than these. In my opinion, the Fed has made the smarter move by biting the bullet and admitting it is wrong early. Christine Lagarde has now painted herself into a corner and THE PAINT IS NEVER GOING TO DRY ENOUGH. When she has to leave this corner, there will be a real mess to fix.

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