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Economy in Brief

Catch 22: German Inflation Meets EMU Growth
by Robert Brusca  January 6, 2015

Even a relatively quick perusal of the EMU trends reveals that deceleration is well ensconced across the euro area. Reading the table from right to left, the 12-month to 6-month to 3-month averages by country and by sector are overwhelmingly getting progressively lower on the more recent horizons. Even the latest month's reading is generally in line with or below these receding trends with few exceptions. Europe is weak and it is weakening. The euro area's overall raw diffusion measure at 51.4 in December bravely stands above the neutral reading of 50.0. But at that level, it also stands meekly in the 48.6 percentile of its historic queue, below its historic median. The EMU reading is higher than this more than half the time, marking this as a weak reading, albeit one that still is signaling growth. And with a trend that is about to splash cold waters on those failing embers.

In addition, the new inflation reading for Germany, a county that traditionally has had the lowest inflation rate in the EMU, has just posted a flash HICP reading of 0.1% year-over-year in December. It is the lowest reading since the HICP fell by 0.1% in October 2009. And oil prices are still plunging in January even as this report, dated as of December was released.

Of course, Germany no longer has the lowest inflation rate in the EMU. But it continues to run low inflation rates and it has the highest weight in determining EMU inflation of any EMU member. That makes this result a strong case that the EMU-wide HICP will continue to be weak and move further away from the ECB's goal for it.

The ECB is surely taking further steps down that road to do something like QE, whatever it can manage even despite German criticism. The ECB and the Germans in particular are in a box. The ECB was beset with rules when it was formed to make it impossible to abuse its powers and to protect its integrity. However, now those very rules are constraining the ECB from acting and preventing it from reaching its targets, thereby eroding its integrity.

If the EMU Commission is going to have any high moral ground to stand on to force countries to toe the line on fiscal austerity, then the ECB certainly cannot be squeezing the life out of inflation at the same time. An inability or unwillingness to boost inflation back to target would seem to provide a rationale for members to decouple from austerity programs where they are in place.

Yet, the Germans do not want the rules governing the ECB's capabilities fiddled with. But if the ECB does not skate close to the edge, it is not clear what of the EMU rules anywhere can be made binding. EMU members did not sign on for an inflation rate zone in which they could not get growth and were not allowed to use fiscal policy. But here they are.

For their part, the Germans are certainly going to be wary of using a QE program since bond yields are so low already; it is all but absolutely certain that this program will inflict eventual losses on the ECB once it is unwound. Interest rates in Europe could hardly go lower. And if the ECB has to take losses, the Germans are the ECB's biggest backer. Inflation, growth and too strict enforcement have put the ECB in a Catch 22 situation.

The expression `catch 22' is from Joseph Heller's famous book of the same name. It refers to a situation in which your discovery of a way out makes that way out no longer viable. Germany has opposed QE for so long that now that inflation has dropped so low it will not be able to stop QE from occurring. Now, at this level of interest rates, the harm QE can do to the ECB might be much worse than what the Germans previously sought to avoid. The ECB may be headed for something much worse than reputational risk: solvency risk. Of course, that depends on how aggressively the ECB is with the `QE' program and how successful the program. But the Germans are clearly painted into a corner as persistent financial conservatism has come full circle to bite them on the bottom.

We can conjure up a mess like this without even resorting to any talk about the situation in Greece. But it is because the baseline EMU situation is so severe that I think the Germans are really serious with Greece. Finally Germany can see how dangerous it is for everyone to be in a zone where the rules are not followed. No one is safe, not even those that followed the rules. They can now clearly see that Germany no longer sits in the cat bird seat.

Germany for years ran the lowest inflation rate in the EMU and racked up some huge competitiveness gains vs. its fellow EMU members, quietly letting them run higher inflation and not pointing out the consequences. Now Germany is finding out that the consequences are not so good for Germany, either. By helping to engineer (at least acquiesce) in such a plan, it has to take some responsibility for the way things are today. Weak growth and poor prospects, fellow members strapped and corseted by fiscal rule with deflation on the doorstep and threatening to get worse, that is where EMU is today. What's left but to unlock the piggy bank known as the ECB to get inflation back to the promised land (or at least the proximity of the land that promised, around 2%)?

There is also the fact that Germany reached its highest ever level of employment in 2014. It has not suffered, but it has pushed austerity on fellow members. No wonder Germany is viewed as the country that can shoulder the budget that it does not want to pick up. Europe is here, not just because of profligate policies by its members, but also because of too strict and unenlightened policies put in place to bring them to heel. A final reason is that although the EMU is a union with shared values, members still act more as competitors with their own agenda that as fellow members seeking fair rules in a union they want to work.

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