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Economy in Brief

ECB Gets Ready to Meet As Inflation Scorches Europe; The Scorching, Greening, and Dashed Dreaming of Europe
by Robert Brusca  July 19, 2022

Europe is not just being roasted by global warming, extremely hot temperatures, and raging forest fires, but also by an extremely overheated inflation rate. The targeted HICP inflation rate for June rose by 0.7%, taking the year-over-year rate up to 8.6%. The core rate slowed in June, rising by 0.1%, after a gain of 0.5% in May, but it's up at a 3.7% annual rate year-over-year in June.

The headline inflation rate shows some cooling in its path as its 8.6% 12-month rate is at a 10.9% annualized rate over six months, then cools to a 6.5% pace over three months. The core rate, however, continues to accelerate from 3.7% over 12 months to 4.2% over six months, to 4.3% over three months.

The ECB at long last is getting ready to raise rates at this week's meeting. There is some speculation that there could even be a 50-basis point rate hike, not just a first-step 25-basis point rate hike. The Bank of Canada just hiked rates by 100bp; last meeting the Fed stepped its pace up to 75bp when 50bp had been expected. The ECB has been struggling with the issue of fragmentation which it's an attempt to deal with the disparate impact of inflation and rising interest rates across various European Monetary Union members. All eyes are going to be on the ECB this Thursday.

Clear, if mixed, inflation trends
Inflation trends in the European Monetary Union are clear. Looking at the four largest EMU economies, the 12-month inflation rates range from a high of 10% in Spain to a low of 6.5% in France with Germany logging an 8.3% pace and Italy logging an 8.5% pace. The progression of inflation from 12-months to six-months to three-months over these countries shows mixed trends – but they are the same mixed trends across these four countries. There is acceleration from 12-months to six-months in all cases. Over six months inflation ranges from 11.9% in an annual rate in Italy and Spain to 9.5% annualized in France. However, over three months the inflation rate breaks lower in each of these countries, ranging between 9.7% in Italy to 5.3% in Germany. All these, of course, are clearly excessive rates and excessive compared to the 2% average that the ECB now aims at. Since the ECB is looking at some sort of (unspecified) average, it is likely that the higher 12-month inflation rates are more relevant for policy than the inflation rates calculated over short periods.

Core inflation trends
Core inflation tells a slightly different story although it's not necessarily a story that is better; in some ways it is better and in other ways the story is worse. The story of core inflation is being told from lower levels of inflation than what we see in the headline. That much is good news. Over 12 months the inflation rate among the four largest EMU economies for either core or ex-energy inflation (ex-energy in the case of Germany) ranges from 3.5% in France to 5.4% in Spain. Over six months core inflation accelerates the same as with headline inflation. It accelerates in each country with the pace of inflation over six months annualized, ranging from 4.4% in Germany to 7.6% in Spain. But now we get to the part where things get worse rather than better. Over three months inflation accelerates in each of these countries. Inflation in Germany is the lowest at 4.7% while inflation in Italy is at a pace of 8.2%; inflation in France comes in at a 5.8% pace while Spain's rate is at a 7.8% pace.

Compares and contrast
Headline inflation in the EMU runs at 8.6% over 12 months and then decelerates to 6.5% over three months. The core inflation rate runs at 3.7% over 12 months but accelerates to 4.3% over three months. The levels of core inflation are more tolerable than for the headline, but the pattern for the core showing ongoing acceleration is more worrisome. These two measures leave the ECB with nowhere to hide.

A longer view
Also worrisome are the five-year results for inflation. The compounded five-year inflation rate as of June for the headline is 2.8%. Despite some persistent inflation undershooting before inflation jumped up, inflation has now become so strong in the recent months that the compounded inflation rate over five years has moved above a 2% pace. Core inflation, however, still fits inside of the objective of the ECB at a 1.6% pace. Looked at in terms of the four largest EMU members, each of them has a five-year average well above 2%. For Spain, the average is 3%; for Germany it's 2.9%; for France it's 2.5%; and for Italy it's 2.3%. However, the inflation rate for the core is still tame: German inflation excluding energy is up at a compound pace of 2.1% arguably at the borderline of acceptability. Spain logs a 1.7% pace, France logs a 1.6% pace, while Italy's pace for compounded inflation is 1.3%.

Excess inflation
Excess inflation is still largely being driven by energy as well as food components. When we exclude those two things and look at core inflation, it is better behaved; however, it is still over the line. Over these longer five-year periods, core inflation appears more suitable. But for how long with that be the case with inflation still running so hot?

ECB policy challenges
The ECB continues to have problems and questions with the outlook for energy in July still in flux. Brent energy prices measured in euros fell by 3.8% in June after rising 23% in May and 9.6% in April. Brent measured the same way rose at a 184% annual rate over the last three months. And there are ongoing concerns about what will happen with energy prices. U.S. President Joe Biden just got back from a trip to Saudi Arabia where he tried to convince the Saudis to pump more oil to help alleviate the stress on world markets. In the immediate aftermath of this trip, it doesn't sound like he was very successful, but time will tell what OPEC-plus will do.

Oil prices vs. supply- Germany makes its first and second mistakes
Quite apart from oil and gas prices, there is the question of availability. Because of the war between Ukraine and Russia and because the West has been supplying Ukraine, Russia has been cutting back on its oil supplies to the West. Europe has a long history of having relied on energy from Russia despite having been warned by the U.S. that this was going to make them vulnerable. Angela Merkel was a 100% supporter of Russia; she believed that Germany could do business with Russia safely and that European and German dependence on Russian oil would not become a factor in the future. These misjudgments about Russia, its danger as an adversary vs. its safety as an energy source, will be the lasting legacies of Angela Merkel undercutting what at the time may have seemed to be a glowing era of leadership.

Russia misgauges Germany and NATO
In fact, these same assessments of the situation and similar misjudgments had been made by Vladimir Putin who thought that Germany's commerce with Russia and its dependence on Russian oil as well as its past reluctance to contribute fully to defenses in NATO meant that its war on Ukraine would keep Germany in its economic fold and would help to drive a wedge through NATO. Putin made the same miscalculation as Merkel. Russia's invasion of Ukraine shocked the Germans as well as the rest of Europe. It has better united NATO. We can now see that this wrong-headed analysis about the German-Russian political and economic linkages encouraged the invasion to happen. Perhaps if Putin had realized that Germany would not remain economically committed to Russia in the face of this invasion, he would not have invaded. And, of course, if Angela Merkel had not allowed this kind of mercantilist dependence to occur, Putin never would have had reason to suspect that such a tie would bind Germany to Russia. Wars often occur because actors misgauge reactions and intentions of their opponents. I think this is an example of that.

ECB is in a bind
However, all this does leave Europe in a tricky situation where it is worried both about the price and then about the availability of oil and gas. This puts the ECB in a very difficult spot because on one hand it should already be raising interest rates to damp the rising inflation and the strong inflation that it has as well as to deal with the growing core inflation rate across the European Monetary Union members. On the other hand, the ECB is wary about raising rates as Russia cuts off energy supplies and undercuts the viability of the economies of the member countries in the EMU. There is no ‘good' way for the European Monetary Union to deal with this.

The worst of times…and timing
These circumstances catch the world economy at a very vulnerable time because it's also engaged in this effort to wean itself from hydrocarbon fuels. While Russia cutting off energy supplies to Europe will simply expedite that process, that sudden withdrawal is very damaging and it was never part of the green agenda. However, now it's part of reality and there's this question about how Europe is going to get his energy in the coming months. Ironically, with hot temperatures and wildfires raging in Europe, it remains a substantial question how Europe will remain warm this winter.

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