German Inflation Delights, But Remains Stubbornly High

German inflation was delightfully low in March, falling by 0.2% month-to-month after rising by only 0.1% month-to-month in both February and January. Over the last three months, the German HICP headline pace has fallen, and is contracting at a 0.3% annual rate, compared to climbing 2.6% at an annual rate over six months, and climbing 2.5% at an annual rate over 12 months. This excellent three-month performance, of course, is also embedded in the too-hot six-month and 12-month rates of change. It serves as evidence that, as delightful as the recent data have been, German inflation continues to run over the top of the target set by the ECB for the European Monetary Area.

Domestic CPI The domestic CPI that has a different weighting scheme shows inflation up by 0.2% in March and February, compared to a 0.1% gain in January. The inflation performance for the German domestic CPI is 2.2% over 12 months, 2.7% over six months and 1.7% over three months. It also behaves much better over three months than over six or 12 months; in fact, the 12-month gain in the domestic CPI is even closer to the ECB's desired outcome. Still, the German inflation rate continues to run hot except over three months. Looking at German inflation and its CPI excluding energy, which was up 0.3% in March, compared to 0.2% in February, and no gain in January. The inflation sequence for German domestic inflation excluding energy is 2.7% over 12 months, 2.7% over six months, and then down again to 1.7% over three months.

Germany displays improved and in fact acceptable inflation over the last three months; however, over a broader timeline, it still isn't good enough for the target that the ECB has for the EMU area. Still, if we look at diffusion statistics which assess the breadth of inflation acceleration across periods, we see the diffusion over 12 months is only 27%, over six months it's only 36%, and over three months it's only 36%. Diffusion at 50% would indicate acceleration and deceleration are balanced. But with diffusion below 50%, that's telling us that inflation is actually decelerating across more categories than it's accelerating. Germany displays impressive decelerating statistics across these categories for 12-months compared to 12-months ago, for 6-months compared to 12-months, and for 3-months compared to 6-months. The reality is that inflation continues to overshoot, that is simply the reality that inflation is stubborn in several important categories where it refuses to fall enough to register the desired result of 2% overall.

However, very clearly inflation in Germany is not running away. It is slightly excessive, and the overshoot depicted by the domestic headline at 2.2% would probably be acceptable in these times, but the overall 2.5% for the HICP and for the CPI excluding energy at 2.7% are still excessive.

How tough should the ECB be about hitting its target? After missing the target for such a long time, hitting it soon becomes more important. But now there are complications. And those complications are probably a good reason to set strict short-term compliance aside…temporarily. However, even in saying this, it is important to not forget that hitting the target really is the objective. Had the ECB (…the Fed, the BOE, the BOJ, etc.) hit their targets earlier, providing slack now would not be so controversial. But the persistent missing of the target by overshooting now puts discretion to allow further overshooting on thin ice. Central banks shooting for a soft landing are now paying the consequences of that choice. They will be paying the price in terms of extending target overshooting and reputational damage.

New risks The world has gotten complicated with the United States pushing Europe to take care of more of its own defenses, something that has already caused Germany to adopt a much more expansive military spending agenda. There will be more of this across Europe and that is likely to push inflation higher rather to extend the trend lower. This is a complication that the European Central Bank is going to have to deal with. In addition, there's the new problem on the block which is that the U.S. has imposed draconian reciprocal tariffs which have since been put on hold and have been replaced with a uniform 10% tariff. The U.S. is engaging in bilateral tariff negotiations with all his trade partners… well almost all its trade partners. The U.S. has stepped up its tariff war with China, as China has matched the U.S. tariff for tariff so that both trade partners now are imposing 125% tariffs on one another's exports. These are the two largest economies in the world; they're going at it with a trade war. There's likely to be collateral damage and that's the warning for Europe.

The tariff tiff Tariffs, to the extent anybody pays them, (trade could just stop) will be inflationary in the short run. Economists point out that tariffs don't really raise inflation; they just raise the price level, and they do it once. Once is not inflation. But tariffs this high are likely to have a larger psychological effect and could wind up having a more pronounced effect on the overall inflation rate, not just on the price level just one-time. In addition, there's the question of what tariffs this large would do to global growth and there's reason to be concerned on that front.

Ripples from the big rock The U.S. has today reported out the widely respected University of Michigan index of consumer sentiment. That index has produced the second weakest reading that it's generated in the last 47 years. That can't be a good thing for the global economy. With these kinds of statistics circulating and countries around the world recognizing that the U.S. is under this kind of pressure and that these trade negotiations are, in the short run, at least likely to be debilitating, the risks of a global slowdown have just stepped up and the potential for global recession has increased as well. I'm not particularly a fan of arguing that it could turn into stagflation. In the short run, there could also be a flare of inflation, although I would expect inflation to be short-lived if recession were to take hold, I'm not in the stagflation camp. But I am worried about the knock-on impact on growth.