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Economy in Brief

EMU Producer and Consumer Inflation Points the Way Lower: Are We Worried?
by Robert Brusca  April 2, 2014

Producer and consumer price trends continue to work lower in the European Monetary Union. At the same time, growth continues to be for the most part slow and uneven. These two trends put pressure on the European Central Bank to act. The harmonized index of consumer prices (HICP) has been below 1% for six consecutive months. In January 2013, the pace was last 2% year-over-year. The ECB, like the Federal Reserve, is confronted with the price performance that is inconsistent with its goal. The ECB is a simple single-mandate central bank so for the ECB the need for stimulus should be quite clear relative to its mandate. While the US central bank is in the same situation relative to its inflation goal, nothing is simple talking about the Fed.

Producer prices show that 11 of the first 12 members of the EMU all have a declining PPI for at least two months in a row (see table). The same members have PPI's declining over three months and declining over six months. Over 12 months, only Ireland among this group has a positive PPI. For Ireland, the year-over-year gain is 1.1%. These are pretty unequivocal findings on inflation and on what it's doing in the euro area.

Manufacturing prices are declining. The best we can say is that the rate of decline in that sector is not eroding at a quickening pace. Manufacturing prices are falling 1.3% year-over-year and they are down to just about a negative 1% annual rate over three months and over six months.

By sector, positive inflation in the EMU is present for capital goods and consumer goods; the pace for each is under one half of 1% over the past year. However, for intermediate goods, prices are falling at a 1.8% annual rate over 12 months and falling over shorter horizons.

Inflation continues to be a problem for central banks, but not the problem it used to be. The problem now is an inflation rate that is too low and it's coinciding with a period of growth that is too low - a situation that gives central banks the creeps.

Central banks traditionally worry about inflation. They worry about inflation getting to be too high. Suddenly the ECB may have a different problem: deflation. Consumer prices in the EMU are not declining year-over-year, but they are very low and trending in that direction. They are at 0.5% at an annual rate. If you're not concerned about deflation in the euro area, then you're not paying attention.

Central banks are worried about inflation picking up nonetheless because that concern is embedded deep in their genetic makeup. I think it's one of the reasons that deflation is able to gain footing; nobody is really afraid that it's going to happen. For the most part deflation treated as a circus freak.

Central bankers understand that low inflation is a risk that can be debilitating to growth. The Fed has added some language to its FOMC statement after a dissent in policy by Jim Bullard last year recognizing that if inflation stays too low too long it can be a problem. But that seem to be about it: lip-service to risk.

The ECB has inflation at or below its 2% target for 15 months. The Fed has a bit of a roller coaster for headline inflation, but the core PCE inflation in the US has been at or below the 2% Fed target since October 2008. Despite its `roller coaster' nature headline inflation has been low on average too. Since the FOMC also offers an FOMC outlook, the Fed sees its core and headline PCE gauges below its 2% goal to the end of 2016. That means the core PCE will be at or below 2% over eight and one-half years in a row! From October 2008 on to end 2016, the US headline and core PCE each will be averaging a compounded annual rate below 1.5%. This, at a time that the Fed has said it could allow inflation rise to 2.5% for a time but instead policy is set to keep inflation at 1.5% for period of eight and one-half years.

The German economy has been able to prosper under low inflation for some time. However, for the rest of Europe, the yoke of the ECB has proved demanding, too demanding. The EMU way of reporting inflation weights a large economy's performance more. Because Germany is the largest economy and typically the low inflation country in the euro area, that has tended to keep EMU inflation inside the ECB target. But a number of EMU members have not kept their inflation low even after joining the EMU. These are substantially the countries that have had the hardest time in the financial crisis. Now these countries are having a difficult time as inflation pressures continue to dial down and their economies have not been geared to thrive with low inflation.

Low and falling inflation may just have become public enemy number-one, but you won't see its picture hanging in any post office or in the lobby of any central bank. Even the Bank of Japan, based on a recent survey, seems to have convinced firms that prices in the future will rise. Nowhere else is deflation taken as a serious risk. Yet inflation is extremely low and falling.

Sometimes when inflation is weak, we take it as a sign of demand weakness. Sometimes it is a sign of excess supply driving prices down. Milton Friedman coined the phrase that inflation is always and everywhere a monetary phenomenon. OK, but what about deflation? The monetary aggregates do not show the kind of weakness that would lead you to think that money supply in the US or in Europe has squeezed inflation lower to this extent. In Europe, credit growth is still very weak; in the US, credit growth has picked up. Central bankers still do not have their arms around inflation. It remains too low and these bankers are already wary that they have done too much to boost the economy even though growth has not responded and inflation still appears to be low and trending lower. Are central bankers guarding against the wrong risk?

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