Early Inflation Readings in Large EMU Economies Show Promise

Inflation charts an uncertain path in the European Monetary Union (EMU). Early-reporting large countries are reporting weak inflation readings for their headlines in September. Three of the four largest EMU economies Germany, France, and Spain report declines in their headline HICP indexes in September. The exception, Italy, reports a headline that's unchanged month-to-month. That’s a “good news” month for headline inflation in no uncertain terms. These numbers follow an August in which two of these countries also had posted headline price declines and where one of them had posted an unchanged index month-to-month. These excellent results for August and September followed July that had been a difficult one with three of the member countries posting month-to-month increases in the headline HICP's ranging from 0.4% to 0.8% month-to-month.

We also have early reporting results on core inflation or (in the case of Germany) for inflation excluding energy for three of these reporters. Here the results are good but not excellent because the German figure shows an increase of 0.3% month-to-month, Italy logs a core index that is unchanged, while Spain logs a core that's down by 0.1%.

Headline HICP- As tantalizing as these figures are, they produce a mixed picture on sequential inflation when we look at the longer inflation picture from 12-months to six-months, to three-months. On the 12-month basis, all the headline readings for these four countries are below 2% which is the target number for the European Central Bank. However, over six months, inflation in Italy runs at a 2.8% pace, in Germany it runs at a 2.7% pace, while in France inflation accelerates but only to a 2.0% pace. Over three months, again headline inflation settles down with three of the four countries showing an annual rate of inflation over three months of a half a percent or less, but with Italy showing an annual rate at 2.6%. These are good results for the headline, with three-month inflation largely behaving and 12-month inflation, the usual preferred gauge of the central bank, below 2% across the board.

Core CPI- The problem emerges when we start to look at core inflation and we realize that a lot of this inflation progress has come because of weak oil prices. We have ex-energy or core inflation for Germany, Italy, and Spain and two of those three countries have year-over-year inflation rates on the core or ex-energy basis that are above 2%. German ex-energy inflation comes in at 2.6% over 12 months, Spanish core inflation comes at 2.4%, while Italian core inflation comes in just under the wire at 1.9%. Over six months, inflation accelerates in Italy from its 12-month pace of 1.9% to 2.4%. In Germany, ex-energy inflation ticks down to 2.4% over six months, while Spanish core inflation also ticks down to run at a 2.2% annual rate over six months. All the readings are above a 2% at an annual rate over six months. But over three months, Italy logs a pace for core inflation that's just barely excessive at 2.1%. Spanish inflation runs back up to a 2.4% annual rate over three months, the same as its year-over-year core. In Germany, ex-energy inflation jumps to 2.8% over three months, stronger than its six-month pace, or its 12-month pace.

Core inflation is still too-high- Headline inflation from the monetary union is certainly encouraging. However, looking a little bit deeper at core inflation which excludes the volatile food & energy components, we see inflation under the surface is continuing to percolate at a slightly excessive pace. The bad news is that inflation is slightly excessive on a relatively broad basis judging from these three economies. On the other hand, while it might be broadly excessive, it is not significantly excessive. Among all these inflation rates, the highest is over three months and it's Germany's ex-energy gain at 2.8%.

A lingering problem- The problem here is not so much an inflation rate that is so high, but that inflation has been over its target for so long. The question is: how long a central bank can keep missing their targets and still retain credibility? In Germany, the headline inflation rate is posting some low numbers, but it's still true that German ex-energy inflation is too high and stubborn. The ECB will find these difficult numbers to use to justify saying inflation is under control. On the other hand, there's nothing here that's terribly worrisome on the inflation front; it's just more of the same excess of inflation that will make investors and market participants wonder if the target is really still at 2% or not. In the long run, that's a problem for central bank credibility and at some point, central banks are going to have to face up to it. If central banks are determined to get control of inflation without creating a recession, they need to get control of it on a timeline that makes the target appear to be still relevant rather than irrelevant.