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Economy in Brief

EMU and Other Central Banks: The Inflation Conundrum
by Robert Brusca  September 17, 2021

As inflation flares central bankers stare
Inflation in the EMU has flared and was last higher in September 2008. Back to December 1997, there were only nine months in which the year-on-year inflation pace exceeded the current gain of 3.2%. For Germany on that same timeline, this is the highest year-on-year pace. While the EMU inflation target only applies to the EMU weighted average, we can also look at each country to see if it is contributing to hitting the target or exceeding it. On year-over-year data, all HICP measures exceed the top dosage for inflation which is now supposed to average 2%.

The target is the target is the target
However, if we take as the inflation barometer the core inflation, or inflation excluding energy (Germany), we find that inflation in France, Italy, and Spain is below the 2% threshold in terms of the core. The German core is up at a 3% pace and core for the EMU as whole is well within range at just a 1.6% pace. However, the target for the ECB is the headline not the core.

Inflation acceleration
Headline inflation by country is accelerating from 12-months, to six-months, to three-months only in France, but the EMU headline also is accelerating on this timeline. In addition, while not showing a monotonic acceleration, Italy, Spain (and non-EMU member, the U.K.) show inflation is running hotter over three months than over 12 months.

Turning to the core rate next, there is steady acceleration in Germany (ex-energy rate) and in Spain. But both Italy and France show pressure as they have a higher gain in inflation (annualized) over three months than over 12 months. The EMU total also has higher three-month inflation than 12-month inflation, but there is a dip in the pace over 12 months preventing an assessment of 'steady' acceleration.

The year-on-year pace of inflation over 12 months is also stronger than the pace over 12 months of one year ago. That is true for the EMU headline and core and all the inflation metrics in the table for all countries.

Table 1

Average inflation
However, the ECB is now looking at an unspecified 'inflation average' and does that ever change the game- see Table 2 below.

The average of the year-on-year inflation rate over 12 months in the EMU is just 1.1% This is a sharp contrast to the simple current 12-month gain of 3.0%. On all these horizons inflation continues to perform admirably running below the proscribed 2% pace ON AVERAGE. The ECB can find comfort in a steady as she goes policy, either by looking at core inflation or by looking at any of the averages of inflation. One of the problems with using an average to suppress an inflation flare-up by averaging it with past low inflation is that eventually this high inflation will become part of the past average and will elevate the average measure in the future even if future inflation comes down to 'normal.' So policymakers must be 'sure' that when averaging is used in this way, they take care to see that inflation is quickly brought lower; otherwise, they will have baked an inflation problem into the cake.

Table 2

Inflation expectations
Chart "Euro Area…" shows expected inflation acceleration/deceleration in the euro area over the next 12 months. Despite current high inflation readings, a large net proportion expect inflation higher in the future. It's a high net diffusion ratio by historic standards

Chart "UK…" offers inflation expectations by the Bank of England's survey. The U.K. has had much higher inflation in the wake of its Brexit announcement and the plunge in the pound sterling that had elevated inflation expectations. Expectations have since come back down but are now on the rise again and to a level above the BOE's target of 2%. Still, the expectation overshoot is relatively mild in the U.K.

That brings us to fresh data on inflation expectations in the University of Michigan Survey for the U.S. CPI. Expectations have 'backed off' in September from very high values in August except for the Midpoint of the middle 50% of the inflation assessment distribution. The University of Michigan data set partitions expectations so we can see what is really diving them. This table also is different from the charts above in that it is an assessment for inflation five years ahead, a period that tends to decouple expectation responses from current commodity price flares of various sorts to focus on the long term. This survey is for the CPI while the Fed targets the PCE. The CPI runs about 0.3% per year hotter than the CPI so think of subtracting 0.3% from these metrics to put the survey in PCE terms. Even with that inflation is running over the Fed's desired benchmark. The median is at 2.9% (2.6% in PCE terms) the mean is at 3.6% (3.3% in PCE terms) and the mid-point of the middle 50% of the distribution of estimates (think of this as a trimmed mean -except it is a midpoint) and at a 3.4% CPI expectation, it is at 3.1% in PCE terms. For five-years out these are excessive gains. We also get a look at the extremes of the distribution. The cut off for the lowest 25% of expectations is at 1.5% while the cut off for the highest 25% of expectations is at 4.8%.

No convergence but optimists and pessimists
As always, there are inflation optimists and pessimists. If we rank the current expectations among the past 24 months each in its own cohort, we find this month's expectations rank from the 87.5 percentile to the 95.8 percentile. Thus, by the standards of the last two years, inflation expectations are high. Ranked on data since 1990, the low 25 percentile estimate is only in its 41st percentile marking it as low, even by the standards of past low estimates. However, the high estimate is at a 74.2 percentile standing which marks is as relatively high among past 'high' estimates. Clearly opinions on inflation are spilt. The top and bottom 25 percentiles seem to live in different worlds…

Since 1990, the median has a 63.4 percentile standing (above its own median) and the mean has a 74.5 percentile standing. However, if we eliminate the top 25% and bottom 25% of expectations the mid-point of the remaining 50% of the distribution, has an inflation expectation of 3.4% which is in the 94.9 percentile. That seems to say that the middle of the road man-in-the-street is worried about inflation.

Table 3

Inflation as expected is moderate…but too high
These are still moderate levels of inflation at 3.5% or less, but these numbers are far too high for a central bank shooting for 2%. And the point I made about EMU and inflation averaging of course applies to the U.S. Federal Reserve as well. The BOE has an inflation survey where it has a number of questions, one of them is whether the 2% target is too high or too low. Interestingly, the overwhelming response to that survey is that a 2% target is too high. Obviously, the British public does not think inflation is good.

So, inflation is here. Central bankers' cups runneth over. For the most part they are looking at core inflation or averaging inflation to justify taking to no action. At this time, different central banks have different reasons. In the EMU, inflation is not that bad if you are willing to emphasize the core -and even set aside the averaging. But hard money countries are uncomfortable, especially Germany, where inflation is having one of its worst infestations -as interest rates remain exceptionally low. In the U.S., there is a lot of politics afoot that is probably keeping the Fed on the sidelines for too long. And in Japan, none of this is an issue with a shrinking population and having fought off a number of growth-killing special problems as well as what appears to be an abject fear of the virus and reluctance to vaccinate.

As always, it is different strokes for different folks. But the virus that brought with it dislocation and supply chain issues has shifted the way the modern economy works, that is still having an impact. There are major differences of opinion about how people should work and that is at a time when vaccines are showing themselves to be much less bullet-proof than advertised. Central banks are betting on inflation being temporary. Using an average to make policy is a way to double down on that bet. We shall see if that is a wise strategy or not.

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