Sticker-Shock Inflation Hits Europe Hard

Inflation in the European Monetary Union (EMU) rose 0.8% in the preliminary reading. Inflation remains strong across the four largest European economies with inflation in Germany up by 1.1% in May, with Italy at 1.2%, with France and Spain both showing 0.7% increases month-to-month in their headline inflation rates. However, Germany reports an ex-energy rate which was up by 'only' 0.6% in May; Italy's core reading is up by 0.8% month-to-month.

Over three months, EMU inflation is at an 11% annual rate, with German inflation at a 15% annual rate, French and Spanish inflation at a 9% annual rate, and Italy's rate at a pace of about 6%. These are still high rates and showing acceleration over three months. Italy and Spain are exceptions to inflation accelerating over three-months compared to six-months.

Inflation does accelerate steadily from 12-months to six-months to three-months in the EMU, Germany, and France. For Italy and Spain, inflation accelerates from 12-months to six-months and then tails off over three-months.

The increase in inflation is striking. The month-to-month rates picked up in May across the board with the lone exception being German inflation excluding energy. The year-over-year inflation rate in May compared to April accelerates for every comparison in the table except for Brent oil prices.

One striking feature is the substantial acceleration for inflation over the last 12-months compared to what it was over 12-months one-year ago. In May 2022, the year-over-year inflation rate is 8.1%; one-year ago the year-over-year inflation rate was 1.9%. That is a massive acceleration. The acceleration compared to a year ago is striking for every single comparison except for Brent oil in euros; for that measure inflation 12-months ago was up 118.5% over 12-months compared to being up 80% over 12-months in May 2022. Both are still quite sizeable increases.

But now China is showing some signs of revival, and oil prices have started to get a lift from that. The ongoing war between Russia and Ukraine raises pricing risks, creates availability problems, and particularly will be hitting food prices very hard. Because of this environment, it makes the outlook for inflation still very difficult. Despite the clear overheated headlines and lesser gains for inflation excluding energy, the outlook for inflation remains uncertain. Everyone 'expects' inflation will be reduced…but how low and how fast?

Central banks are obsessing about the difference between headline and core inflation for policy purposes. In Germany, for example, headline year-on-year inflation is 8.8%, but ex-energy inflation is only 4.6%. For Italy, headline inflation is 7.4% while core inflation is 3.5%. The excluding energy or core inflation rates are still uncomfortably high, but they don't carry the sticker shock that headline inflation has.

Central banks seem to act as though headline inflation doesn't really apply to them or their policy and they act as though they can conduct policy as if the core or excluding-energy inflation rates were the true inflation rates. However, we don't know that those core rates will continue to be the core inflation rates of the future and we don't know how soon headline inflation pressures will abate.

In the meantime, the man on the street must pay the total inflation rate not just the core inflation rate and that's become a problem. If headline inflation rates don't abate soon central banks are going to have a problem because they have delayed so long in raising rates. At some point, this could develop into a credibility problem for the bankers. Not only are interest rates very low compared to headline inflation, interest rates also are still very low compared to core or ex-energy inflation rates. No matter where central banks look to try to find a benchmark, it's clear that monetary policy has gotten well behind the curve. It's not clear how long we are going to continue to pay a price because of that delay. But Europe is not alone in shouldering this risk.