The ECB: Inflation and the euro

The ECB’s policy meeting last week received scrutiny for the apparent lack of activism given the weak August core inflation print (0.4%YoY, the lowest on record) and recent euro strength. Indeed, the FT’s editorial board lamented “the ECB’s lukewarm euro intervention.”

There were two key issues to confront in last week’s meeting, therefore. The first was what to do about the euro. The second how to interpret the August inflation print. Let’s go through each in turn.

Regarding the euro, as pointed out by Mark Sobel, the G7 and G20 have agreed that explicit action on the exchange rate is unacceptable as a policy device. The former has agreed that monetary and fiscal policy should be targeted at domestic policy objectives. And this same imperative is embedded, though coded, in the IMF’s Article IV since the second amendment. As such, central bank governors cannot be seen to be talking down exchange rates per international protocol. 

The fact that Lagarde was previously the Managing Director of the IMF made it especially important not to rock the boat. So, while the FT laments the ECB’s lukewarm intervention on the euro, it’s more reasonable to lament why the FT would imagine Lagarde would take a more active role pushing against euro appreciation.

Turning to inflation, the record low August print for Core inflation was indeed remarkable. Then again, there are many factors making interpreting HICP inflation at this time difficult. Consider the following: 

The German 2-3ppts temporary VAT reductions from July were announced too late to be factored into the June forecast, so this temporary VAT impact was weighing on price pressures. Germany has a weight of about 28% in the euroarea HICP.

Another complicating factor continues to be the use of imputed prices in calculating goods which are no longer trading. While Eurostat published guidance in April on the need for imputed prices and keeping weighs constant as well as other issues.

In July further Eurostat guidance was offered on the reintroduction of price measurement and changing quality. But even then, missing prices could require imputed entries by statistical agencies still especially if these are partial openings, such as hotels and other holiday venues. 

What proportion of prices in HICP were imputed? It is not clear in the aggregate. But for a discussion of the share imputeD prices in Germany, which reached 22.4% in April but is now about 1.5%, here is Destatis. Note, imputed prices in recreation was still 8.5%.

Add to this unusual holiday seasonality. August was impacted by cheaper accommodation across the periphery in an attempt to woo tourists. For example, Greek tourist arrivals were down 94%YoY in June. While this is deflationary near-term, whether mark-ups will have to be increased to restore profitability later is an important open question.

Moreover, as noted by Lagarde and explained by Italian statistics office (ISTAT) summer sales in 2020 began on 1 August rather than, as in 2019, on 1 July. As such, headline HIPC held up in July 2020 more than otherwise, contributing to the sharp MoM decline in clothing and footwear in August. 

Finally, this inflation exercise also has to be confronted with possible changing weights due to COVID-19. HICP weights change annually based on spending patterns in period t-2. This means 2022 weights should reflect 2020 spending patterns—which may, or may not, be persistent. 

There has been a shift in spending from services to goods, and the latter is more volatile. This could be important for HICP in 2022. Goods today are 55% of the basket, services 45%. How should this be weighed when projecting inflation over the relevant horizon?

And this should also be seen against the backdrop of the fact that the June inflation forecast—before the German VAT reduction—was already very conservative. 

The ECB June forecast had full year HICP at +0.3% for 2020; over the first 8 months YoY HICP was running at 0.5% and if the YoY headline remains unchanged through December, we end up with full year of 0.3%. So, the June HICP forecast was actually pretty aggressive already and headline inflation was bearing this out. In this sense, it was not unreasonable that the headline inflation projection for 2020 was unchanged.

Admittedly the composition of HICP outcome has been different to that expected, but given the complexities noted above it is reasonable that some caution be taken interpreting HICP prior to the full lifting of lockdown measures or the “normalization” of spending patterns. 

Forecasting inflation past 6 months is difficult and over 2 years near impossible. It is right to allow some time for more data to emerge.

That said, Philip Lane’s blog following the policy meeting raises some important questions. Indeed, the most surprising aspect of yesterday’s projection update was the upward revision of Core HICP from 0.9% to 1.1% in 2022. What were the reasons for this?

Well, Lane explains that upward revisions were due to improved fiscal policy, including 1ppts of GDP additional discretionary measures in 2020 and NGEU lowering bond yields and (presumably) financing conditions compared with June. Against this, a stronger euro weighs on core, but does not completely offset the positive impact of fiscal/financial.

This suggests a domestic demand led Core HICP recovery relative to the June forecasts, yet in euroarea current account is seen as returning to 2.6% of GDP in 2021 and remaining there in 2022, both greater than projected in June. There is hardly any imprint of this domestic demand narrative on the aggregate current account, therefore.

Moreover, if such fiscal policy tweaks are, according to the ECB’s models, able to shift Core inflation 0.2ppts over a two-year horizon even allowing for the associated exchange rate appreciation, then the ECB should not be congratulating fiscal policymakers for their recent enlightened interventions, but encouraging them to do more to allow the price stability mandate to be reached in quick time. This would be associated with a smaller current account surplus, of course. But this is necessary to put back demand into the global economy after years of free-riding.

In summary, there were good technical reasons for being cautious about recent inflation numbers in the euroarea. A wait-and-see approach was reasonable; there will be time to react to incoming data between now and Christmas. But if domestic demand is indeed expected to pick up, boosting Core inflation with appreciation is pressure growing, this ought at least be reflected in the current account.

END.