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Economy in Brief

European Inflation Remains Sticky
by Robert Brusca  January 19, 2022

Monthly inflation is weaker in December
EMU inflation is high and rising. The month-to-month grinds broke lower in December as EMU-wide inflation gained by 0.3% after a 0.7% rise in November. Rising by less month-to-month was inflation in Germany where the monthly inflation gauge fell by 0.2% after a 1.3% rise in November, in France where the inflation pace in December went flat after a 0.4% gain in November and in Italy where a 0.8% November gain 'withered' to a 0.4% rise in December. Spain showed an acceleration in the monthly gain to 1.4% in December from 0.2% in November.

All series show left-to-right acceleration; all series have a small curling at the end (Dec.)

Brent oil prices backtracked in December falling by 11% after rising by 8.7% in November. Ex-energy inflation in Germany ticked up by a slower amount rising by 0.5% in December after rising by 0.6% in November. In Italy, core inflation accelerated to a 0.5% monthly gain in December from a 0.3% rise in November.

But what about the pace?
The year-on year pace for the HICP is 5% in the EMU in December; that is up from 4.7% in November. The pace for 12-month gain in prices in December is weaker in Germany as the pace fell to 5.7% from 6% in November. It is unchanged in France at 3.4%. Inflation stepped up in Italy to 4.2% in December from 3.9% in November. And it stepped up in Spain as well rising to 6.6% after a November gain of 5.5%.

Clearly the forces of inflation are still strong. The ECB may have shifted to an inflation averaging approach, but all of these inflation results are too high, and averaging is not going make everything okay again – or is it?

In Germany, ex-energy inflation stepped up to a 3.9% gain over 12 months in December from 3.6% in November while Italian core inflation rose by 1.6% in December from 1.3% in November. While Italian core inflation stepped up, it alone remains within the boundaries set by the ECB. And that is not enough. But averaging can work a different 'magic on these trends.

ECB policy
ECB policy as described by Christine Lagarde continues to look for no policy change in the year ahead. The ECB believes that inflation is going push itself back into the tube it squirted out from without any external help from the central bank. This had also been the opinion at the Federal Reserve, but that opinion has changed sharply in the past few months as inflation has risen to levels that were quite unexpected by the central bank. In the ZEW survey released yesterday, the ZEW financial experts have been impressed by Lagarde's position and they foresee less upward pressure on EMU short-term rates as a result (less than in the U.S. at least), but they do expect short-term rates in the EMU to rise. So we will be watching trends and the ECB's policy statements closely.

Table 1

Inflation targeting and averaging
The EMU-area sees inflation rising with trend among the largest economics but still somewhat mixed. Inflation rates all are excessive apart from core inflation in Italy. And the sequential pattern of inflation from 12-months to six-months to three-months shows EMU-wide inflation is accelerating from 5.0% to 5.8% to 7.1%. These sequentially annualized rates are shockingly high and bear no relationship to the ECB's inflation objective which is to average 2% inflation. However, inflation averaging is tricky as Table 2 below shows. Table 1 shows point-to-point annualized inflation rates as well as a five-year average. Table 2 shows the average for 12-month inflation over various periods: 12 months, 2 years and so on. Despite HICP inflation at 5% over 12 months and gaining at a 7.1% annualized pace over three months, when the year-on-year pace is averaged across the most recent 12 months, the average is 'only' 2.6%. Because inflation has been so low for so long previously the current average gain is muted. Averaged over 2 years, 3 years, and 4 years, the pace is in the neighborhood of 1.4% to 1.5%. And those numbers are well withing the ECB's target framework. Presto! Inflation change-o!

The results are much the same across the four largest economics with Italy and France as partial exceptions. For France, the current 12-month average is at 2.1% and that is just a tick above the objective. For Italy, the pace is at 1.9%, a tick below the ECB objective. But Spain has a 12-month pace that averages over 12 months to 3.0% and Germany's averages to 3.2%. However, on longer averages all four countries show inflation well in range – even low!

Table 2

While averaging does not bring inflation to heel over 12 months, it does make it seem less worrisome. However, for a careful policymaker, the impact of letting these high inflation rates accumulate in the averaging process for periods ahead also must be considered. Inflation runs at a pace of 3.2% in August (y/y) and steps up to a higher pace each month thereafter. The current averages for inflation are low because of prior inflation: 2.4% in July, 2% in June…0.7% in January. Any policy that relies on say a 12-month average of 12-month inflation to be the target will be encountering higher averages in six months or so – unless the pace of inflation were to drop sharply. So, procrastinating on rate hikes now can create a more uncomfortable future unless inflation really does- not just stop rising- but stops rising and starts retreating in a major way. Using longer-dated averages may mitigate the immediate problems of using an average, but they bake the same issue into the cake for a longer period – a more entrenched but less pronounced effect.

If Lagarde wants to, she will have averages pointing to still 'in target' inflation for some time to come depending on how long of an average she is willing to look at (one year, two years more?). But that approach is going to load lots of current inflation into the averaging pipeline and make mischief for the central bank later. The real question is why not begin to withdraw some stimulus in the presence of so much inflation when no one can be sure how much of it will be lasting and how much might evaporate on its own? Why roll the dice, instead of act, especially when interest rates are clearly too low for long term sustainability? In this policy tact, Lagarde is pushing ideology onto the ECB and fighting back at the old Bundesbank (and early ECB) notion that any 12-month violation of the inflation yardstick was tantamount to a crime and required a policy response. Taking away that automaticity is a good thing. But if automaticity is replaced with judgement, then judgment needs to be used and hopefully not applied through the filter of ideology.

ECB policy will be important to watch. It will be especially important as the Fed hikes rates – and the Fed will do that in 2022. Monetary policy in Europe is going to be in play one way or another. It is either going to push back against some uncomfortable inflation news and watch as European market rates shift in reaction to bond yields rising in the U.S. Or the ECB will change its mind and join the process of rate hiking. Or inflation will fall, and everyone will live happily ever after! So far, Lagarde is clear and not vacillating about rate hikes in 2022. But will that position stand the test of time? Just five days ago, Lagarde said this:

"Our commitment to price stability remains unwavering," she said in a speech. "We will take any measures necessary to ensure that we deliver on our inflation target of 2% over the medium term." "We understand that rising prices are a concern for many people, and we take that concern very seriously," Lagarde added (Source here).

Lagarde also argues that some of the collateral impact of inflation is a drag on growth and that is an automatic braking of sorts that already is occurring. But will it be enough? Markets are beginning to line up and to challenge that view. Lagarde's promise that the ECB will “take any measures necessary” underlines that she does not 'intend' to let inflation run wild but has a different view on how the inflation process will play out. This is how we know that, if she is wrong, she will respond and hike rates…eventually. And markets are beginning to price in the end of sub-zero borrowing costs but only eventually. While the ECB is not the Fed, it may be instructive to remember how demonstrative the Fed was about using language to fight inflation and try to convince markets that inflation would heal itself…until it was forced to use policy. The ECB could find an equally significant and rapid shift awaits it in 2022 as well.

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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