Some Hopeful Signs in European Inflation Trends; But Are the Signals Good Enough Given the Circumstances?

The Circumstances- The chart of the three largest EMU economies and their HICP inflation rates shows clearly that year-over-year trends and inflation in France have broken lower while Italy, that has long had the lowest inflation rate in the monetary union among the four largest economies, is on a mild uptrend. Germany has made a very small re-set as inflation has broken lower in the short-run, but German inflation year-on-year actually would still appear to be in a slight uptrend.

There is good news- Despite these broader views, there is some excitement over this month’s inflation statistics from Germany. German inflation has fallen by 0.2% in March after rising by only 0.1% in February and in January. The annual rate change for inflation in Germany over three months is -0.3% which compares to France at -2.1%. These are clearly good inflation developments for the two largest economies in the monetary union; however, Italian inflation over this period is at a 5.7% annual rate while Spain's inflation is at a 1.2% annual rate. Among the four largest monetary union economies, three of them have short-term inflation rates well inside of the ECB's targeted pace for the union as a whole; however, the picture is far from completely clear.

There are reasons to be cautions in digesting the ‘good news’ - Italy shows a clear acceleration for inflation from 2.2% over 12 months to 2.8% over 6 months to a pace of 5.7% over 3 months; that acceleration is uncomfortable. For Germany, the year-over-year inflation is in excess of the EMU-wide target at 2.5%, and still excessive at 2.6%, and accelerating slightly over six months, but then it breaks sharply lower over 3 months to that -0.3% pace. France has relatively clean results with a one way read on inflation. Over all horizons, inflation’s pace is below the 2% mark and decelerating to boot running at a 0.9% annual rate over 12 months, followed with a 0.2% annual rate over 6 months, and then clocking -2.1% at an annual rate over 3 months. Spain is a good example of the mixed situation for European inflation as over 12 months it's 2.3% pace is slightly above the 2% that the ECB seeks for its EMU-wide target; over six months Spanish inflation steps up to a 3.4% annual rate, clearly excessive on everyone's radar, but not really worrisome, then, over 3 months, Spanish inflation settles down to only 1.2% at an annual rate- highly copacetic.

The inflation overview: numbers and their trends- Summing up what we have here are three countries with 12-month inflation above the 2% pace. France is below it at 0.9%. We also have three countries with inflation above the 2% pace over 6 months with France as the exception again at only 0.2% over 6 months. In addition to that, two of the three countries show acceleration over 12 months compared to 12-months ago, and over 6 months compared to the 12-month pace, inflation accelerates in three of these four countries. It's possible to look at these data and find good news; however, it's also possible to look at these data and find that the news does not appear to be quite so good.

Beyond the headlines- Turning to the core inflation rates for Italy and Spain, we see that both of the core rates for those two countries are at 2% over 12 months within the ECB's desired parameters and a green light for any pending rate cut decisions. Italian core inflation runs at 1.9% over 6 months with Spanish core inflation at 1.7% over 6 months also acceptable paces to the ECB. Over 3 months the Italian core picks up to 2.4% annual rate while the Spanish score remains at 1.4% and as part of a decelerating process for Spanish core inflation from 12-months to 6-months to 3-months.

Strong core support for rate cuts from two reporters...but - Results for core inflation make a much stronger case for the ECB to consider rate cuts if it wants to do so. But the other thing to keep in mind is that there is also a step up in military spending going on in Europe that should help to underpin demand and in the process of accelerating growth there's a very strong chance that the decline in inflation is going to stop and that inflation pressures could develop.

What if.... If the ECB were making policy in the spirit of the old Bundesbank, I don't think there's any way this set of conditions could possibly lead to consideration of rate cuts in this environment. However, while the ECB carried over the Bundesbank charter, it made some modifications to it, and with the breadth of the European Community behind it, rather than just the Bundesbank and Germany's traditional fear of inflation, it's highly likely that the ECB is going to see the inflation-growth trade-offs to be much different than the Bundesbank would have in similar circumstances.

The rate cut door is open- That's likely leaves the door open for another rate cut from the ECB in the short term even though macroeconomic conditions soon to be affected by coming military spending do not argue for more stimulus. If military spending comes on stream sooner and has a bigger impact on growth, but if the ECB still cuts rates in advance of that happening, it would just make the case more likely for the ECB to stop rate cutting and then to commence a new cycle of raising rates a little bit earlier.

What do conditions demand? What is the objective? Let's remember that what's disappointing in Europe is mostly GDP growth and not underperformance of the labor markets. The labor markets in Europe are still very strong. If we judge them from unemployment rates, the unemployment rates for most of the European Monetary Union members are well below their historic medians and much closer to their historic lows. In fact, the EMU itself, on a weighted basis, has the community unemployment rate at its historic low. Should the ECB choose to cut interest rates, it will be cutting them purely for stimulating growth and possibly in anticipation of keeping any deterioration from the labor market, although with pending military spending that's a pretty weak argument to make at this point in the business cycle. I think we are going to learn from the ECB when we see if it decides to cut rates or not, is just how much of a hawk or a dove the ECB wants to be in this environment. Holding rates where they are makes the most sense since the ECB has this long period of overshooting on inflation behind it. It would be a strange time for the ECB to take a plunge to rate reductions on inflation that is still running too high relative to target while unemployment rates are still performing so well. In this case, I would say that the conduct of the ECB is going to tell us an awful lot about its intentions and its willingness and desire to fight inflation in the coming months, which is going to be more important as military spending ratchets up.