Core HICP Shows Building Upward Pressure

Headline inflation in the euro area appears to be disciplined as it rose by 0.1% in June after rising 0.2% in May. Headline inflation is up 2.5% over 12 months, up to a 2.9% annual rate over six months but then simmers back down to a 1.8% annual rate over three months. There's some volatility there, but the three-month inflation rate is reassuring. However, is that what the ECB is really looking at?

Rotten in the core? The core inflation rate is an entirely different animal in June. It rose by 0.4% in June, it rose by 0.3% in May, and it rose by 0.4% in April. None of these month-to-month increases is acceptable. Looking at the performance of the core rate sequentially, the core is up by 2.9% over 12 months, it's up at a 3.2% annual rate over six months, and then it accelerates further to a 4.1% pace over three months. Each of these profile rates, taken on its own, is too-high; but the sequence taken together is even more disturbing because it shows that core inflation is too high and accelerating, from just short of 3% to just over 4% as the venue shifts from a 12-month calculation to a three-month calculation.

Inflation in the large economies of the EMU and in the U.K. The four largest economies in the monetary union show headline inflation is generally not behaving. Germany, France, and Italy each show that inflation is increasing over three months compared to six months; while in two of those cases the six-month inflation rate fell compared to the 12-month inflation rate, the three-month inflation rate in each of these countries is higher than its 12-month counterpart. The three-month inflation rate in Germany runs at 5.4% compounded, in France at 3.5%, and an Italy at 3%. Among the largest four economies, the only one with inflation behaving is Spain where the 12-month inflation rate is 3.6%; then it drops to 2.9% over six months and logs a three-month pace of inflation at 1.7%. This is another disturbing sequence of numbers for the ECB. By comparison, nonmember U.K. shows headline inflation low and decelerating.

Core inflation is slightly excessive Core inflation shows inflation has accelerated in France and Italy relative to its 12-month pace. For France, the three-month core inflation rate is at 2.6%, up from 1.9% over 12 months; in Italy, the core is at a 2.8% pace over three months, up from 2.1% over 12 months. Spain shows inflation behaving at 2.1% over three months compared to 3% over 12 months. Germany shows ex-energy inflation behaving at 2.1% over three months, compared to 2.6% over 12 months. Nonmember U.K. shows a core inflation pace up to 3.6% over three months after a six-month lull and a 3.5% pace over 12 months.

Role and goal of the ECB Of course, the ECB targets inflation for the entire European Monetary Union (EMU) and is not particularly interested in the inflation performance in any specific country compared to the performance of the union. However, since we have country specific information, just as it's interesting to look at that inflation as at inflation across commodity categories. When we do this, we find that inflation is either not well behaved in its headline or not behaved in its core form. So the details are not confirming that overall inflation is behaving the way it ought to. And, as noted above, when we look at the headline, inflation appears to be behaving, but when we look at the EMU-wide core rate, which excludes the volatile food and energy components, we see a very different picture. The core is accelerating and running at a 4.1% annual rate over three months, approximately twice the target that the ECB has for inflation.

So where do the ECB policy trade-offs stand? These calculations raise question marks about whether the ECB is really close to cutting interest rates in this cycle or not. There's been a lot of talk about cutting interest rates; there's a lot of talk from the U.S. about cutting interest rates as well. We include the U.K. inflation rates in this table and U.K. core inflation appears to be stuck, stubborn, and possibly even accelerating. Having central banks that want to engage in a policy in which they cut interest rates, puts policy in a dangerous spot. They need to know cuts are fully supported by the underlying inflation dynamics. Neither the U.K. nor the ECB seem to be on very solid footing on that score. In the case of the U.S., inflation is beginning to trend in that direction but it hasn't firmly established the trend for the headline and core especially not for CPI as well as PCE rates. Of course, when we switch our gears to talk about the Federal Reserve, the targeted inflation rate is the PCE and not the CPI. Fed Chair Powell in the U.S. has recently referred to this and confirmed that the Fed's target is the PCE; however, he has also noted the unusual decoupling of the PCE rate from the CPI rate. Were the Fed to cut interest rates at a time that the PCE is behaving and the CPI is not, there's a good chance that could create some blowback in the markets. Whether we look at the U.S. or Europe, we see a good deal of policy dissonance.

We have seen the future, and it has rate cuts…but when? For the time being, markets everywhere are looking for central banks to reduce interest rates. And while we look at short-term trends in the table and talk about them for the U.S., it's clear that the future is a very different animal with a live war going on in Europe, severe and destabilizing problems in the Middle East, and saber rattling out in the Far East. If the future is going to require more military spending, it's going to be a more inflationary future, and maybe central bankers should think about whether or not cutting interest rates now is appropriate with inflation still walking a thin line that doesn't reaffirm that inflation expectations or inflation are firmly entrenched at their target pace. However, there's been very little talk of this in central banking circles. For the most part, central banks are looking at past trends and talking about inflation immediately ahead of them. But with inflation cycles still cooling off the boil, in the United States and Europe and with some changes in political leadership in Europe, central banks may feel set upon or obligated to inject some interest rate remedy. For Europe, the challenge is newly ensconced administrations in the EU, France, and the U.K. In the U.S., it is oncoming national elections in a hotly contested environment.