German PPI Fails to Ring Alarm Bells

Inflation trends in Germany continue to move up toward or to the 2% mark. And 2% is a micro-step over the line to Germans and to the ECB. The German CPI has just got to that mark while the ex-energy CPI continues to pace at a good margin below the 2% mark with no sign of ongoing acceleration.

So what’s the risk and here’s the beef?
As always, let me make the point that inflation targeting in the EMU is not about German inflation but about EMU-wide inflation so I am using these inflation benchmarks for illustrative purposes with full knowledge that the ECB is not at all concerned about German headline inflation being at 2%.

Is the core a cop out?
Moreover, the ECB has shifted its gaze to the core inflation measure since it has been persistently lagging below the headline and the headline continues to be boosted by oil prices. We see that inflation spilt in the German data as well as in the EMU data. German officials –were they the policymakers- might be more willing to ignore that distinction and base policy on what they might view as marginally excessive rates of inflation based on the headline. That is not policy reality. However, what this observation does point up is how policy anxiety in Germany generally may be more acute than it is in Frankfurt at the offices of the ECB.

Is oil an exception or does it rule?
Oil, however, remains the main inflation culprit. And we know that oil price gains represent a hike in the relative price of oil and that unless monetary policy slips up oil price gains are not actually inflationary. A monetary policy that actively raised interest rates because of oil price gains would be excessively restrictive. Such a policy puts added monetary braking on an economy that is already trying to cope with a rise in the relative price of oil. The key to blocking inflation is not to make policy accommodative and to prevent oil prices gains from spreading and becoming inflation elsewhere. That is the real challenge for the ECB.

ECB policy already looks to be too accommodative to many; when viewed by classical yardsticks, it is. But the economy is not having a period of normal growth. And it is not clear what the current level of accommodation actually contributes to inflation given the ongoing economic distortions. This discussion is not as prevalent in Europe as it is in the U.S. where there is a growth mandate as well as an inflation objective for monetary policy. There, the U.S. has developed the concept of ‘R-star’ that looks at the noninflationary level of the policy interest rate. That approach admits that the equilibrium Fed funds rate is lower than it used to be. Transferring this approach to Europe means that in Europe the correct adjusted policy rate should be lower than it traditionally has been. Of course, this is already widely recognized. Still, it is hard to calibrate what this means precisely. And there are still those locked in the old ways of doing business who want to deny it and go back to ‘old normalcy.’

Not with eyes wide shut...
One way tell about the proper policy is by opening your eyes and seeing what policy does. Right now ex-energy inflation is underperforming. So the nonoil inflation rate is a better gauge to evaluate policy, not just because of oil, but because of what we could call the ‘R-star’ problem. It hardly looks as though monetary policy is pushing inflation over the brink in the EMU. Moreover, mushrooming problems in Italy and new banking systems risks owing to new conditions spawned by Turkey may be further impeding growth and raising new risks and could keep moving to policy normalcy on hold for longer.

Inflation is no longer a one-trick pony
On balance, inflation simply is not behaving the way it used to. Economists really do not seem to have it sorted out at all. Some see a new world with new constraints; others continue to cry ‘wolf’ on inflation based on old operating parameters. Policy clearly needs to sort things out. Europe may be more vulnerable than the U.S. as the dual mandate may insulate the U.S. economy better against bad policy in this environment. If the ECB reverts to the belief in old-fashioned inflation models when Draghi’s term ends and if policy becomes more forward-looking, it could turn out to be persistently too tight. One thing we saw in the financial crisis was that Germans were not unhappy with a ‘too low’ inflation rate as the German economy still operated well in that environment, but the same could not be said for the rest of the euro area.

Post Script...
By the way, let me wish a happy-end-of-austerity to Greece on this fine day and wish the Greeks better luck in the future as their austerity program officially ends today. And while it is the official end of that program, it will not be the end of their need for austerity. Greece still has a huge overhang of debt waiting for it down the road. Sometimes the end marks a new beginning. Sometimes it is just mislabeled as ‘the end’.