Economy in Brief

Measured on the HICP headline scale, German inflation has reached the promised land. Sequentially Germany’s HICP measure is up 1.9% over 12-months up at a 1.9% annual rate over six-months and much weaker at a -0.6% annual rate over three-months. A year ago, the pace of the HICP was 2.6% so this slide of German inflation into its overall target zone for European Monetary Union-wide inflation rate has been slow and relatively consistent.

The German domestic inflation measure isn't quite as well behaved and shows more signs of simply being stable skimming just above that hallowed 2% mark. A year ago, German domestic inflation ran at a 2.2% annual rate, currently, year-over-year it's at 2.1%, the six-month pace is at 2.3%, the same as the three-month pace, which is 2.3%. None of these are deal-breakers for monetary policy since German inflation has been within a couple of ticks of the desired path even on this domestic scale now for over a year, tracking the target that the ECB seeks for the monetary union as a whole.

However, a good deal of inflation progress continues to reside in the behavior of oil prices Brent oil prices are down for three-months in a row and they've certainly helped to contribute to good performance on the overall and domestic inflation measures. Germany's domestic CPI excluding energy was up 2.6% a year ago, currently it's up by 2.8% over 12-months it's up at a 2.6% annual rate over six-months, and at a 2.7% annual rate over three-months. Once energy is excluded, Germany's domestic inflation measure is steady, much like its headline measure, however it's skimming somewhere between half a percent and eight-tenths of a percentage point above the 2% target that the ECB sets for the European Monetary Union as a whole.

The point of saying it that way, talking about German inflation compared to the target for the monetary union as a whole, is to remind everyone that there is no target for inflation in Germany there's only a target for the monetary union as a complete entity. But Germany is the largest economy in the monetary union; what Germany does goes a long way toward putting the overall European measure in its proper place. Currently Brent inflation is down 27.7% over 12 months, it's falling at a 25.4% annual rate over six-months, and dropping at a 60.3% annual rate over three-months. These sharp declines in energy prices certainly go a long way toward making the headline inflation pace for Germany as well as for EMU behave.

The HICP measure doesn't give us up-to-date energy readings yet so we cannot calculate comparable statistics for the monetary union as a whole. However, the German data are quite suggestive that if we were to do that, we would find a similar outcome, that the HICP headline appears to be well behaved but that the core would probably appear to be a little more stubborn. Regardless of that fact, the question is where the ECB would come down with its discretion. And recently central banks have been quite tolerant about inflation-overshooting. However, that worm may have turned.

A new future…unfolds or unravels Economies now face different challenges. Europe is going to be in charge of more of its own military defense and that's going to require more spending; that will create more stimulus and possibly generate more inflation pressures. In addition, there is this tariff imbroglio that could resolve either with a closer-to-free-trade result with tariffs being reduced, or a worse-result with more tariffs being imposed. A world with more tariffs or higher tariffs would be a world that was likely to be flirting with inflation a little bit more, at least over the next year or so. The ECB might still continue to be tolerant of that. However, a lot about these economic circumstances remains unknown. There's a lot of uncertainty about the performance of the US economy that can help to set the stage for how the global economy is going to perform. So, the future still offers the potential for more economic drag from a high tariff world or lower inflation performance from a lower tariff world and it's still hard to judge which of these worlds we're going to be in over the next 12- to 24-months. And now, German headline inflation is behaving quite well although the core reminds us that Germany may be farther away from its goal than the headline makes it appear, like that famous rearview mirror image in the movie Jurassic Park. Looking at things through mirrors can distort them. And at this point I don't think policymakers know exactly how to look at the future whether they know the rearview mirror from the windshield or the future from the present. There's a great deal of uncertainty, a great deal of disagreement and very little trust. Stirred together, it's not a good combination for policymakers. Double, double toil and...trouble? We shall see.

Forecasting is an ordinary part of economic analysis. And to a large extent, it gets taken for granted as we realize different people are making different forecasts and that there always are differences. We come to accept that, and we realize that there may be some economists who are more optimistic and some who are more pessimistic, some who favor growth more, some who fear inflation more. There are almost always some sorts of biases involved when people make forecasts simply because it's very hard to eliminate bias completely no matter how hard an economist tries to be objective. At the very least, economists usually feel somewhat bound by the previous forecast that they made in order to provide some stability in the guidance that they present.

The ZEW Forecasts In this month’s ZEW survey, there is an example of this with what I consider to be somewhat quizzical forecasts being offered by the ZEW financial experts, who are largely European experts, at a time that the United States is threatening tariffs. Now this, of course, makes the U.S. the aggressor in this campaign and according to the ZEW experts the U.S. is going to suffer from this more than European economies. However, the U.S. is much less trade-dependent than Europe and certainly far less dependent than Germany which is one of the most trade-dependent large, advanced economies in the world. We measure trade dependency by looking at exports plus imports as a percentage of GDP. By this measure, trade-dependency is around 90% to 95% of for Germany; U.S. dependency is around 30% to 35%. The ZEW experts see the tariff situation making the U.S. economy much worse off than the European or the German economy- why?

Tariff impact To put this in perspective, in the U.S., high tariffs, if they are binding, will cause imported goods to be more expensive. U.S. firms and consumers will have the choice of deciding whether they want to pay the higher costs to consume those items or to replace them in consumption or their production process. In the case of consumers, it's probably easier because a consumer can switch from an expensive French champagne to a less expensive but still quite good California sparkling wine or Chardonnay- or pay the higher price and enjoy French champaign! However, if U.S. consumers shift, that is going to leave France with a lot of unsold champagne and they need to sell it someplace else and that's a problem since the U.S. is a huge high-income market; that’s the reason that it's sought after by so many countries who export to the United States. U.S. consumers may choose to be satisfied with a different product. In this example the French, or it could be the Germans, or anyone whose exports are distained because of higher prices, might find that they have goods piling up in the shelves that they are not selling. This could cause an unemployment problem that could really snowball- a more severe problem than drinking Chardonnay instead of French champaign!

The U.S. side On the U.S. side, if people continue to buy these goods, the U.S. will have more inflation that may cause the Fed to stop cutting rates. The Fed might even raise rates, and this could slow the economy down. However, as we know, tariffs are one-time increase in the price level and it's only if the Fed runs ‘bad monetary policy’ that the price bump caused by the tariffs would become inflation… inflation is a persisting increase in prices.

The new ZEW in May In this new survey, we see the economic situation in May improving relatively substantially in the euro area, as well as worsening slightly in the U.S. and in Germany. We see macroeconomic expectations sharply higher in Germany in May and while they also improve substantially in the U.S., the U.S. is left with economic expectations that are weaker less than 5% of the time, while German macroeconomic expectations are above their historic median (above a ranking of 50%).

Got inflation? Inflation expectations are falling in the euro area in May and in Germany and, while they edged slightly lower in the U.S., they rank very high - higher only 8% of the time in the U.S. Whereas inflation expectations are lower only about 20% of the time in the euro area and in Germany. What's interesting, is that we see a big decline in inflation expectations in the euro area and in Germany despite the fact that growth conditions either improve or hardly unchanged and macro-expectations for Germany get sharply higher and yet inflation is improving. This has to be viewed as a curiosity.

Interest rates Short-term rate expectations in the euro area are more negative than they are in the U.S. with both the euro area and the U.S. having low rank standings for short-term interest rate expectations. Long-term rate expectations in Germany and the U.S. show a decline both in Germany and in the U.S., but the German rank-standing is at its 15th percentile and the U.S. standings in its 36th percentile. That, at least, matches with the inflation expectations outlook.

Through all this, stock markets are improving in May compared to April. The European stock market and the German market are doing better than they are than the U.S. on a queue standing basis. And the dollar is expected to get weaker.

This week, we focus on US-China trade developments in light of the economies’ joint 90-day tariff pause announcement. The extent of the interim tariff cuts has surpassed investors’ expectations. As such, the cuts have understandably boosted sentiment in Chinese equity markets (chart 1), though sentiment had already been buoyed by the increasingly conciliatory tone in US-China communications leading up to the announcement. The tariff cuts are a significant reprieve for both economies. The US is likely to see reduced price pressures on producers and consumers in the near term, while China stands to gain from a temporary easing of growth drags amid ongoing domestic challenges (chart 2).

Turning to the hard numbers, China’s April trade readings were relatively resilient, partly due to significant front-loading ahead of the prior US-imposed 145% tariffs taking effect (chart 3). As shown in chart 4, sharp declines in shipments to the US were more than offset by rising exports to Asian partners, including ASEAN, India, and Taiwan. Looking ahead, with the tariff pause beginning around mid-May, we may not see a full month’s data capturing trade responses to the earlier steep tariffs.

Next, we turn to how investors and analysts are responding. In the May survey, our Blue Chip panellists continued to mark down growth forecasts across several economies relative to end-2024 expectations (chart 5). At the same time, they raised US inflation forecasts and lowered China inflation forecasts (chart 6). However, these forecasts are likely to see favourable revisions in future surveys—barring new adverse developments—especially in light of this week’s positive news.

Latest US-China trade developments Financial market sentiment has remained fairly buoyant despite the flare-up in US-China trade tensions in April. Recent messaging from both sides has moved away from the fiery rhetoric of previous months, adopting a more conciliatory tone aimed at de-escalating rather than intensifying frictions. Encouragingly, developments earlier this week reinforced this shift: the US and China issued a joint statement agreeing to a 90-day cooling-off period as they pursue trade talks following a relationship “reset.” During this time, the US will reportedly reduce its 145% tariffs on Chinese imports to 30% by May 14, while China will lower its 125% tariffs on US imports to 10%. Markets have understandably reacted positively, as seen in chart 1, with this move representing a significant rollback of mutual tariffs and bringing rates much closer to their pre–“Liberation Day” baseline. As a result, the growth-dampening effects from elevated tariffs are now considerably more muted—though it is worth noting that these measures remain temporary.