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Economy in Brief

German PPI Breaks Sharply Lower
by Robert Brusca  November 21, 2022

The German PPI broke sharply lower in October with the PPI excluding construction falling by 4.2% month-to-month; it rose 2.4% in September and 7.9% in August. The sequential growth rates for this headline PPI show a 34.5% rise over 12 months, a rise at a 30% annual rate over six months, and a gain at a 25.4% annual rate over three months. The inflation process shows a clear slowdown but still very high rates of change in headline producer prices.

But there is a huge gap between the PPI and the PPI excluding energy. The PPI ex-energy did not move lower this month. It rose by 0.5% in October, the same as in September; in August it rose by 0.4% month-to-month. The German PPI excluding energy is up by 13.4% over 12 months; it's up at a 6.1% annual rate over six months, and that drops off to a 5.4% annual rate over three months. I have plotted the ex-energy PPI in the chart above.

Like the headline PPI, the PPI ex-energy shows a deceleration in progress despite the much lesser role of oil and the exclusion of energy prices from this index. Most interesting is the huge gap between the growth rates of the PPI excluding energy and the headline PPI. The PPI ex-energy rises 13.4% over 12 months while the headline PPI rises by 34.5%. That's close to three times faster. Obviously, energy and commodity prices have a lot to do with what's been going on with inflation.

The October reading marks the first observation in the fourth quarter. Fourth quarter-to-date inflation for the headline is falling by 1.3% at an annual rate, but for the core it's still rising at a 5.5% annual rate, in line with its sequential progression.

Monetary policy and prices
Monetary policy of course is made at the European Monetary Union level by the European Central Bank not in Germany by the Bundesbank. However, Germany has a high weight in the monetary union and its price developments are important period; it's instructive to look at the difference between the German CPI and the PPI to see what's going on with different metrics for inflation. Through October the German CPI is rising at a 10.4% rate year-over-year, the same as over six months; the pace rises to a 15.8% annual rate increase over three months. The CPI does not show the same headline drop-off that the PPI does since it accelerates. The PPI gives energy and commodities a much greater weight and the services sector is substantially diminished. The CPI and PPI are quite different.

Likewise, the CPI excluding energy is up by 6.5% over 12 months; that pace accelerates to 7.8% over six months and accelerates further into double digits at an 11.3% annual rate over three months. One month into the fourth quarter, the CPI is rising at a 16.7% annual rate where the core is up and 11.5% annual rate.

Oil and OPEC
Underlying these statistics is oil. Brent oil prices are up by 10.8% over 12 months; they fall at a 23.3% annual rate over six months and fall at a 38.3% annual rate over three months. Clearly the weakness in oil prices has been helping the headline prices to behave. However, oil prices fell by 7.2% in August and by a further 7.5% in September but then rose by 3.2% in October. OPEC is trying to put a floor under oil prices and that may make the progressive results for the PPI headline just a little bit less relevant.

Happy days are here again?? Probably not...

The small table to the left shows the correlation between Brent prices and the percentage change between Brent prices and the percentage change in prices for the PPI, the PPI ex-energy, the CPI, and the CPI excluding energy in Germany. The highest correlation is that of 0.5 for the Brent price level and the PPI price level. The correlation between the PPI headline and Brent prices on a percentage change basis falls to 0.4. Ex-energy the level-to-level correlation is 0.44 and in percent change terms the correlation is 0.51. The correlation with the German CPI is 0.37 comparing price level to price level, slightly larger at 0.46 when we compare year-over-year percentage changes between the CPI and Brent prices. The correlation to the CPI excluding energy is only 0.27 when we compare price levels; in percentage terms that correlation drops further to 0.15.

So, at its best the oil price can explain about half of the variance and the PPI headline price level. Or about 50% in the PPI percent change excluding energy. However, we move over to the CPI the correlations fall and for the more important core we have a price level to price level correlation of 0.27 and a percent change to percent change correlation of 0.15 which is quite small. And this explains why the PPI headline can be showing a raging inflation that then decelerates sharply while the CPI excluding energy shows how much lower inflation rate but one that is steadily accelerating.

There's nothing in the month’s inflation readings that is unusual or out of the ordinary. This is simply how oil prices impact the economy in Germany. This is a reminder that while people get excited about the headline and about oil prices, breaking inflation is really a much broader phenomenon and oil prices only really create inflation in the short run and they don't really have a lasting impact on inflation unless monetary policy makes mistakes. This month the greatest deceleration of inflation is for the PPI excluding energy, not the headline. But that development does not reverberate through the CPI.

Impact on markets
The headline and core rates of the German PPI this month are going to be like raw meat to hungry animals. The markets are going to jump all over this; what they want to see is that inflation is breaking and news that the central banks have much less work to do than they had thought. But there are two caveats here: One is that the break in inflation is not coming to the price indexes that central banks most closely watch, follow, and target. The second is that there's a hint that even Brent oil prices that have fallen are starting to move back up. We know that OPEC has an agenda, and it has cut production to try to stabilize oil prices. OPEC is not interested in letting all prices continue to languish at low levels.

These are warnings to look before you jump on these market signs of good news. As is always the case, you'll probably make money by buying the rumor and selling the fact, which in this case means believe in the headline at least in the first instance and then come to your senses sometime later. There's little evidence that inflation really is breaking. Oil may have done all the breaking lower that it’s going to do. In the U.S., the economy is doing so well, and consumer spending is holding up so well that anything that causes markets to improve, thereby improving financial conditions increases the likelihood that the Fed will have to raise rates more not less. The Atlanta Fed GDP-nowcast puts incoming data on U.S. growth for Q4 at over 4%. In the case of the ECB suspect it will be much the same, but the ECB has been much slower to act compared to the Fed and the extent of its inflation resolve has yet to be demonstrated.

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