Changing Trends for Euro-Inflation and Austerity

HICP inflation has finalized for the EMU and prices fell by 0.6% over the last 12 months on balance, a significant short fall from a target rate of `just under 2%.' Note that a comparable miss on the upside would have inflation at 4.6%. The table shows few instances of period-to-period inflation accelerations in train. Spain is the exception with `core' inflation rising to a 0.7% pace over three months from 0.1% over six months and with that six-month pace being an acceleration from zero over 12 months. Italy also shows on isolated acceleration, again in core inflation, for six months compared to 12 months. The overall EMU core rate has a technical or unrounded acceleration to 0.5% over six months to that same pace over three months. In the table, without more decimal detail the rates look the same.

We choose to show a chart of Spanish vs. German HICP inflation. Until 2013, having Spanish inflation lower than German inflation was a real rarity. Since then, it has become the norm and not because Germany has reflated- quite the opposite. There has been so much deflation in the euro area since the financial crisis that now when we look at the average inflation rates by countries since EMU formation few stick out as real problems. However, Spain is still `bad' on this measure as it has averaged inflation of 2.4% (Luxembourg has averaged 2.45%) compared to the EMU averaging 1.9% and Germany 1.5%. You can infer that Spain has still lost a lot of competiveness ground to Germany having averaged inflation of nearly one percentage point more per year during the entire time of the existence of the single currency area. That helps to explain why Spain is under so much pressure now to catch up.

Austerity is about changing habits, controlling fiscal excesses and bringing the local economies into alignment around the right rate of inflation. It is also about getting back into shape. To use a diet analogy it is not just about learning to eat correctly right now; it is about losing the excess pounds gained. Meanwhile, Germany diets and exercises every single day. Germany keeps fit. Its inflation rate stays low and its budget is kept in order. So making progress on Germany that continues to act like that is very hard. It explains why Spain has been near zero inflation since mid-2013. Spain's HICP still has grown by 17.6% more than Germany's HICP since the EMU was formed. But that is down from a `worst divergence' that at one time reached 27.7%.

There is no doubt that the single-minded focus on austerity has brought EMU competiveness into smaller orbits around Germany. Germany is still number one, but its weighed average gap with the EMU is now down to 6.4%. France is only 2.8 percentage points behind Germany. Ireland is only 8.4% behind, Italy is only 10.6% behind and Greece is only 10.7% behind. These metrics represents some enormous progress and have come with some substantial pain.

While Germany can take a good deal of the blame for the pain and for being such a stern task-master, the approach has achieved progress as the data clearly show. The question is if the progress can be kept and built upon or if the pain has been too great and if that will lead to austerity departures.

Inflation data show that the EMU is well below its targeted metric even if we consider core inflation it is quite distant from the metric that the ECB targets. So the pain we see is not wholly on the back of weak oil prices. Growth lags within the EMU and that helps to grind inflation lower for many reducing the competiveness gap with Germany further.

Aggregate data do not always tell the whole story as Italy is a country of a north very different from its south. The north houses the efficient Italian industrial sector and the south, well, does not. Italian data today show that Italy has just posted its second annual current account surplus with this year's surplus nearly twice what was posted for last year. Still, Italy is a country with some deep rifts caused by the implementation of austerity and the removal of many of the `benefits' the `way of life' to which Italians had become accustomed.

There is evidence that you can teach an old dog new tricks- but also that it is painful and politically dangerous even de-stabilizing. Is Greece now compliant?

Greece has offered up its plan today and the plan makes interesting reading. I contend that you cannot tell by reading it what Greece will do. Germany has not commented on the Greek plan publically, but the plan seems to have been accepted. Greece is still under a lot of pressure as its HICP is lower by 2.7% year-on-year. I expected Europe to accept the plan because on its surface it sounded reasonable. But I also expected that `acceptance' comes with strong vigilance to remain in place because it is quite clear that the document Greece has offered also has many loopholes. Greece still has a long road and tough jobs ahead because it now needs to make its economy viable under its new policy regime.