Germany Paves the Way…for Bad Monetary Policy?

Headline inflation is showing signs of behaving in the European Monetary Union (EMU). In March, German inflation saw the monthly change in headline HICP fall by 0.3%, in France it fell by 0.4%, in Spain it fell by 0.4%, while in Italy it rose by 0.1%. The year-over-year increases in the HICP headline inflation rate show a 3% increase in Spain, a 2.4% increase in France, a 2.1% increase in Germany, and a 1.3% increase in Italy. Italy wins the kewpie-doll for attaining its 2% goal first! The target for inflation in the EMU is at 2%; it’s for the whole union. The large economies in the EMU are only starting to bring their respective year-over-year inflation headlines in line with the ECB target. However, the year-over-year inflation rate in the monetary union has been excessive for the last 29-months. That's a lot of overshooting.

The way we are- In fact, 29-months is one month short of 2 ½ years. With a 2% inflation target, prices should have risen by about 4.8% over this period if the inflation rate had progressed at its top targeted pace. But the price level instead rose by 15.5%, a tremendous overshoot. Any contracts geared for (and written depending on) 2% inflation over this period have been blown out of the water.

Central bankers plan ahead- Central banks are eager to point out to us that they need to start reducing interest rates before the inflation rate gets down to their target; otherwise, they risk ‘overdoing it’ and crushing the inflation rate, making it ‘too-low’ and putting ‘undue stress’ on the economy. We know that monetary policy works with a lag, and we have reason to believe that this is a reasoned analysis of the problem.

But have they made the right plans? What central banks have not communicated to us effectively is why the right rate to look at to make policy is the headline rather than the core inflation rate. In March, we only have a core rate estimate for Italy and Italy's inflation rate is already running at the weakest pace of any of the large for monetary union economy. However, it's also interesting to note that the year-over-year Italian core inflation rate is 2.4% while the Italian headline is at 1.3%-more than a percentage point lower.

Isn’t this relevant? Above, we show the up-to-date year-over-year percent changes for headline inflation through March for the four largest monetary union economies. We reprise that data in the table below showing you the specific numbers that apply to the inflation rates in the graph as well as showing results for Italian core inflation and for Brent oil prices expressed in euros. A second chart which is up to date only through February (because core inflation isn't yet released for March) shows that the core inflation rates are generally much higher than the headline inflation.

Rate cuts ahoy! Still, the ECB seems to be prepared to follow through with rate cuts later this year as everyone is talking about the prospect of a June rate reduction. The Federal Reserve has been talking about interest rates having hit a peak for some time and it was beginning to lay out likely schedules for rate cuts this year until some of its recent inflation data showed that inflation progress had stopped, based upon three- and six-month inflation rates. Then, some of the key core inflation rates and ‘otherwise modified inflation rates’ that the Federal Reserve and monetary economists monitored began to turn higher. It may be too soon to tell if that phenomenon is going to follow suit in the European Monetary Union or not. But there is some evidence that the drop in the core inflation rate is starting to slow and even the drop in the headline inflation rate has begun to slow. The question after 29-months of overshooting on the inflation target is this: Really? Is this the right time for the European Monetary Union to be considering reducing interest rates? What message does that planned reduction send to us about how the ECB really views its target? The ECB did shift from a target for inflation that was to be ‘below 2%’ to something around 2% muddying the waters of exactly what they're trying to achieve with the inflation rate. Monetary policy works best in a world of precision, rather than one of ‘horseshoes and grenade standards’ of accuracy. The Federal Reserve has similarly talked about trying to achieve an average for inflation without giving us any idea what average it might be looking at. Both central banks have been overshooting their inflation targets for some time.

Is there something in the water – or the atmosphere? It's very clear that something in central banking has changed. The Federal Reserve does not have the backbone to fight inflation at once did. The ECB adopted a charter very similar to the charter of the Bundesbank that it was supposed to model itself after. That was supposed to burnish its credibility. Instead, the ECB has turned out to implement monetary policies in a way much different than we would expect the Bundesbank would have over the same period.

Targets vs. support for them- It has become clear that what’s not important is the target that the central bank adopts or the charter of the central bank itself, but rather the support the central bankers get from the political environment in which they operate.

The Bundesbank not only had a very tough charter, but the singular inflation mandate made policy only for Germany where stable prices had an extremely high priority. The ECB makes policy for all the monetary union and there are a number of countries in the monetary union that have been much less focused on keeping the inflation rate extremely low. It's also true that when the monetary conservatives in the EMU had the upper hand, especially regarding debt to GDP ratios, they implemented extremely harsh policies on members who were in violation of the debt covenants that were agreed to under the monetary union pact. They insisted on austerity that was extremely painful and probably excessive. What we are seeing now in the implementation of monetary policy as the backlash from that kind of focus.

The debt pacts are an add-on because fiscal policies are not pooled in EMU- We know how seriously some countries in the monetary union take their debt to the GDP ratios. There has been a huge dust up between the United States and Germany over Germany's refusal to spend the agreed-on NATO proportion of GDP on defense both before and after the Russian invasion of Ukraine. Past presidents Barack Obama and Donald Trump tried to cajole and pressure Germany to meet the 2% of GDP spending target. Germany refused preferring to continue to run budget surpluses and pay down its debt (reducing its debt-to-GDP ratio) rather than to implement the new 2% spending targets in NATO even as the U.S. ran huge budget deficits to support NATO among other things.

What does a 2% target mean in 2024? The question for monetary policy now, with central banks refusing to modify their 2% targets, what do those 2% targets mean? Central banks have a 2% target but refuse to hit them…so, what good are they? However, were central banks to modify their targets to something higher like 3%, as the Federal Reserve has been urged to do, their targets become meaningless. A target that can be changed as a target has no value. However, a target that isn't changed but isn't hit doesn't have much value either. The question we should all have for central banks is this: what does this 2% target mean?

The way we were... Prior to the COVID. We thought that a 2% target meant the central banks were going to exert a lot of effort to make sure that inflation was going to be very close to 2%. And all central bank communications reinforced that. Now that there has been a long period of inflation target-missing, central bankers have begun to talk more about being concerned about ‘over-tightening’ and about ‘creating excessive pain’ as we have moved from a period when central bankers would be laser-focused on achieving their inflation targets to one in which they're more concerned about not creating excessive pain and at the same time tolerant or complacent over inflation overshooting their once-ironclad targets. It's far from clear where this leaves us in terms of central bank policy and in terms of what investors should expect.

Central banker success has led to failure- After a long period of price stability, a stability that bought by this credibility that central bankers had from keeping inflation low, market participants have come to view 2% inflation as something that is going to be supported by a certain unseen force of financial gravity. People seem to think that if central banks do very little, inflation by itself will gravitate back to the 2% mark. There's little appearance that any investors are terribly worried that central bankers haven't been hitting their targets! Even now, with bankers not hitting their targets and preparing to cut interest rates, they are relatively more worried about conditions of unemployment and growth than about achieving their inflation targets. No one seems to care. The bond market vigilantes in the U.S. are receiving Social Security instead of trading bonds.

History-we are making history here- you might not like it- History warns us of the kind of mistake that this is. This is a superior first-order mistake for which a price will be paid in the future because inflation that is allowed to gain traction today is inflation that gets greater tomorrow. There should be some lesson here about learning from history and not repeating past mistakes, but there's no evidence of any investors having learned this lesson. Among central bankers there appears to be either a similar complacency or greater concern about the degree of political pressure that will come to bear on them if they do not focus more on reducing the unemployment rate or keeping it low. This oddly comes at a time that, at least in the United States, with unemployment having reached a 50-year low and for which we need to go back 70-years to find something lower than the low in this cycle. The U.S. unemployment rate is only a half a percentage point above that 50-year low. In Europe, the unemployment rate in the monetary union is at its lowest that we've seen since 2000. Meanwhile, both in the U.S. and in the monetary union inflation continues its long overshoot of the inflation target. This is a stranger situation for the European Monetary Union where the central bank has only a price stability goal. The Federal Reserve must deal with a more complicated dual mandate. But even there, its policy choice given current economic realities is hard to understand. Strange days…Do stranger ones lie head?