Inflation: Is That All There Is? Or Is there More?

Different strokes for different folks The ECB has been under growing pressure and criticism for its lackadaisical approach to inflation. As the year began, Christine Lagarde assured everyone that policy was in control and that there was no reason for a change in policy in the year ahead. But then as the month of February began, a different view was expressed opening the door for a policy move. The new view is that “Inflation is likely to remain elevated for longer than previously expected but to decline in the course of this year” (Christine Lagarde, here). So, the ECB views risks as more tilted to the upside. The days of stonewalling the excesses of inflation in the EMU are gone. But it is not clear how much policy action will now be employed to face what is a substantial overshoot in the monetary union that is ongoing with more risk than previously believed. The ECB is no longer saying a policy rate increase this year is very unlikely. So much for what in the U.S. they call ‘forward guidance.’

The Fed burned that bridge a while ago although it is far too soon to say that the ECB is now going to walk the same walk as the Fed. It certainly is not talking the same talk. But now the policy-change door is open.

The ECB had previously focused on how inflation would run-off and how some of the very factors causing inflation to rise would eventually cause to slow. Now that view seems to apply only to the letting off some steam and not able to achieve a full-blown return to target by itself.

Still, in Germany, the largest economy in the EMU, the January HICP and core rate both had made a clear turn to a lower rate of expansion (both still quite excessive relative to the EMU-wide target rate, of course).

There is a new dynamic at work that will bear watching. The HICP elevates from 5% over 12 months to 7.7% over six months to a 9.3% annualized pace over three months. There is a similar but slightly slower price progression for the German domestic CPI. The core HICP and the domestic core rate also show progressive inflation but with less acceleration. When we run correlations on the change in inflation over 12-months compared to 12-months ago then repeat that exercise comparing the annualized core pace over three months to the pace over 12 months we find very different results. The correlation for the change inflation over a year vs. 3-months shows a lot of differences. The simple correlation on these two series registers -0.22. The changes in inflation over the two horizons are not positively correlated. They are negative, therefore inversely correlated. Something different is happening

This suggests that the inflation process is changing. It is changing from transmitting the shock impact to the maturing and spreading stage. And while three-month inflation is higher than 12-month inflation by as much as 4 percentage points on the headline or as much seven tenths of a percentage point on the core measure, the chart at the top of this report shows that the year-on-year pace is falling for both the headline and the core.

For Germany, the bet on inflation slowing is already paying off. But the pace is too high still even for the core at 4.4% or 4.8% -it’s more than double the target. Part of it is oil prices as we can see the Brent oil price is lower for three months in a row. Meanwhile, the acceleration in Brent prices over 12 months (vs. 12 months earlier) is over 40% while for the three-month pace vs. the 12-month pace the deceleration is at a 40% pace as well.

Over three months compared to 12 months, five CPI categories already show lower inflation (transportation, other, health care, communication, and education). The task for the central bank will be to make sure as the inflation process matures and spreads unevenly to be sure that inflation also slows. The ECB admits that sitting and watching is not a strategy. But spot oil prices are on the move up again as the Ukraine situation weighs on the global economy. There is cause to be vigilant. Still, there is some good news on the inflation front to be embraced.