EMU PPI Pressures Still Strong, but, but, but...

The ex-construction PPI index rose as much in April as it did in March. The three-months growth rate of the PPI edged slightly below that of the six month pace but both were elevated relative to the 12-month pace which at 6.7% is still quite high. Needless to say there is not much that is good going on with EMU wholesale price trends.

Having gotten that point out of the way the question is now what is the ECB most worried about? It certainly looks at the PPI although the HICP is its main price gauge on which it places limitations. But with the sharp slowing in jobs in the US and the slowing signal quite clear across Europe is there enough slowing in train for the ECB to set aside its inflation worries as it did in the height of the financial crisis?

In short what does the ECB believe?

ECB's religion - Earlier this year the ECB believed that inflation was a problem and it initiated a rate hike. That tightening process has been put into abeyance, however. The search for a successor to Jean-Claude Trichet tells us that that the ECB may not be as tough-minded on inflation as it might have become. Axel Weber bowed out of the race to succeed Trichet, whose term expires later this year, even though he was the front runner when Weber found his strident brand of German anti-inflationism was not well-backed across the Community.

ECB quandary - Some are a bit more concerned with the ECB's foray into 'fiscal policy' by accepting too-low rated bonds for its collateral. That may yet prove to be a problem. But for now it is not the balance sheet issues that dog the ECB but its posture on rates and view of the current risks.

Look at the zone as individual pieces not as single whole - A part of the assessment of the Zone's needs does have to do with ongoing debt issues in the Community itself: what Greece does, how Portugal responds what Ireland needs, how successful Spain can be and so on… All of this will have important consequences for financial stability and growth. The simplest effect to grasp will be the extent to which weakness will be transmitted across the zone because of new austerity measures that might be adopted. The various MFG and Services PMIs across the Zone have been weakening even in Germany where the Zone's strength has been centered. But, take Germany out, and the rest of the Zone is no stronger than Italy has been. Mix the German data back in and weight it for the size of the German economy and the Zone seems much better off. But if you look at the pieces in isolation it is the clear that a bifurcation or trifurcation emerges: there is Germany, the muddling through group and endangered group and these groups threaten DOWNWARD migration. The IMF, a month ago, warned that the debt issues in the Zone could spread to the core. This suggests that more is learned and understood about the Zone by looking at its various pieces than by looking at the amalgamated whole.

Dealing with risk Vs certainty - But risk of an event is not the same as its occurrence. Still to deal with a risk is to deal with a problem preemptively. To deal with the event itself is to wait and chase after the problem The ECB still shares a strong legacy with the Bundesbank on keeping inflation in check. Still, that does not answer the critical question of where the greatest risk now lies. In the financial crisis the ECB was able to put its inflation limit aside and cut rates with inflation still over the top of tis ceiling, on the expectation that prices would fall. And fall they did; inflation fell then prices fell. The trade off now is not as extreme on either end but the dilemma is of the kind.

A typical dilemma-NOT -- Central banks always face this sort of issue. Since the ECB is not a dual mandate central bank its choice is usually quite clear. But choice is make more difficult in the presence of uncertainty when the potential for loss is greater. While this episode is no financial crisis it is clear to everyone involved as well as to the spectators with the front row seats that there is danger here and thing could get much worse. It is that extra element of risk and potential loss or crisis escalation that sparks policy controversy.

PPI legacy: Can't overshoot when you have no target - The ECB will not be reacting to an overheated PPI. One reason is that the PPI does not have an official ECB heat gauge. But the PPI, at this still strong rate of growth, does not make the ECB's job any easier. On the other hand, a weaker global environment must make the ECB just a bit more reluctant to be tough. The decision it makes will depend importantly on what the HICP does. The PPI will only provide some color and not much more than that.

Jean-Claude's Choice - Right now the ECB's targeted headline HICP is still over the top and through April it is still accelerating. At 2.8% Yr/Yr it is too high. But the core is only at 1.7%. That tells us that if commodities prices settle down and if the euro remains strong the headline inflation will go away and drop below 2%- although one caveat is that the core rate has been accelerating quite noticeably. So the transition from excess to acceptable inflation, may not be so quick or smooth. Global weakness can have exactly that effect. Oil prices have broken down a bit. We can see both why the ECB has backed off on the rate hiking and why it remains vigilant and wary. Time will tell if this stance morphs into strong vigilance or not. Right now it's a razor's edge and a judgment call. In my view the ECB is still more wary of doing damage to the economy by excess braking than by insufficient rate hiking as global growth slows and commodity prices wobble lower. But these remain unsteady and not dependable trends. We will see how long this posture lasts.