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Economy in Brief

German Inflation Ticks and Tocks Ahead
by Robert Brusca  August 11, 2017

The HIPC shows German inflation up by 0.1% m/m in July. The German CPI shows it up by 0.3% m/m. The German CPI and HIPC indexes now show marked divergences over three months, six months and 12 months.

The sequential inflation diagnostics in the table show that inflation diffusion across the CPI categories is (barely) over the neutral reading of 50 for diffusion over three months at 54.5 (54.5% of the categories show inflation accelerating on a three-month venue compared to a six-month venue). Inflation is cooler over six months with a lower headline gain at 1.1% and a diffusion reading of 36.4 compared to 12-months. The 12-month rise in the CPI at 1.7% pairs with a core reading of 1.9% and a diffusion value of 81.8 that seems to ring warning bells as prices are accelerating in all but 20% of the categories! However, the 12-month diffusion reading compares inflation over the last 12 months to 12-months ago when inflation (over the previous 12-months) only ran at 0.4% with the core at 1.3%. Diffusion calculations on inflation rates are relative things. On closer look German inflation has been moving up. But part of that stems from the macroeconomic condition of the German economy, not from a simply too-lax ECB policy.

Comparing HICP-reported inflation where the data are in (Austria, Belgium and Finland have yet to answer the bell in July), we see that Germany is tied for third place in ranking the 9 countries in the table on year-over-year inflation. At 1.5% Germany is above the EMU HICP pace of 1.3%. But since Germany has such a large weight in the EMU data, Germany itself is responsible for much of that inflation outcome. Of the nine countries in the table, only four have year-on-year inflation rates in excess of the EMU total (but those four high-inflation countries include the largest economy in the EMU and the fourth largest along with the smallest of this group {Luxembourg} and another of moderate size).

The table reminds us that Germany is the traditional low inflation country in the EMU. Since the EMU was formed, only Germany and France have inflation rates that have averaged below the mark for all of the EMU.

Among the countries in the table, most have been 'inflation compliant' as only Luxembourg and Spain have inflation rates averaging above the ECB goal of a little less than 2%. Portugal is a technical violator with an average inflation rate at 2.02%. Germany has built its competitiveness led by running an inflation rate that has averaged a full one half of one percentage point below the EMU target. There are no country-by-country targets. But in doing this, Germany has perpetuated and extended its competiveness leadership position and also allowed other countries to run higher rates of inflation and yet to keep ECB policy 'compliant' since the ECB target is a weighted inflation result that gives Germany a large weight. Interestingly, this year Germany's trade surpluses, a clear representation of German competitiveness, are on the rise again after a brief period of falling.

Monetarism? Keynesianism? Don Quixote-ism?
Europe, like the United States and Japan, continues to run with inflation below target and in Germany as in the U.S. the natives are restless to raise rates. While policymakers tell us that the business cycle does not die of old age, policymakers themselves seem to think their own 'business cycle alarm clocks' for inflation are going off... tick tock! Monetary policy has been too easy for too long. Labor market conditions are not as slack as they once were. Maybe they are tight? Inflation is coming to Europe (to the U.S. but not to Japan!) as surely as winter is coming to Westeros...or is it? What theory is predicting inflation? Inflation expectations are so tightly under wraps if they were a Christmas gift we'd have to start unwrapping them now to get them open by December 25. Money supply growth is not excessive. Sure the unemployment rates are low but the Phillips curve could be name for a new pancake served at IHOP - but only served without syrup so it would stick in your throat. Remember wage gains remain small. Policymakers are really tilting at windmills here. They are simply afraid of making the same-old, same-old, mistake (staying too loose for too long) and are putting themselves in jeopardy of making another famous cyclical mistake- tightening policy too much too soon in the wake of a financial crisis.

Policy by fear
Running policy driven by the fear of making the same old mistake is not likely to deliver optimal results whether you are a stuck-in-your-beliefs German in Frankfurt, a frustrated Keynesian in Boston or a believer in mean-reversion in New York. Policy is best made with some reference to theory- every policy needs a framework. But there is also the scientific method that requires observation and verification. That old Milton Friedman phrase that 'monetary policy works with long and variable lags' is a 'get out of jail free card' to some. They think it means that current economic condition can be ignored because THEY KNOW that pressures are building and inflation is coming (winter is coming). I like the GOF (Game of Thrones) analogy although it works in reverse here. The meisters in GOF 'know' that winter is coming, it always has and it always will and it has always been survived. What's the worry? On the other hand, there are those who have seen things that others do not believe. And they are sounding the alarm but are being largely ignored. The analogy is flipped since the mainstream in our case knows what theory warns of; its fear is that, despite repeated observations that the predictions of theory are not in train, there is still a problem (ignore that man behind that curtain!). And so they ignore the warning signs (flat Phillips curve, shifted Beveridge curve, low labor force participation rates, etc.).

The real world: Jurassic Park and the Dinos are loose
Meanwhile, the Fed meisters are still selling tickets to watch the show in the Dino arena. The real problem for our modern real world is that we also have real things to explain why there are departures from the theoretical predictions, the anomalies, if you will. We can see the impact of aging on the labor force, the drop in participation rates that are largely unexplained across moderate age cohorts, the impact of technology software and robotics, the internet and outsourcing as well as of stepped up global competition and the facile nature of global corporate relocation. Yet, policymakers cling to and are fixed by their fears. They find succor in stroking their Linus blankets of theory and from their thumbs in their mouths. They want to make policy based on their fears... based on the relationships from the 'old normal' while ignoring the excess capacities of the real world, the technologies and the globalization of the new normal which mobilize slack from aboard to undercut the impact of apparent tightness at home. I don't understand the hard headed adherence to old theories and rules that so clearly are no longer applicable. But this is what is driving policy and as long as it does the risk of overheating will be small and the risk of underperformance - or worse - will grow.

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