Great Graphic: EMU Inflation Not Making it Easy for ECB

The Reserve Bank of New Zealand is credited with being the first central
bank to adopt a formal inflation target.
  Following last year’s
election, the central bank’s mandate has been modified to include full
employment.  To be sure this was a political decision, and one that
initially saw the New Zealand dollar retreat.  

The dual mandate that originated with the Fed has been questioned in the
US, but Congress has shown little enthusiasm for changing it. 
The
dual mandate would seem to give officials greater flexibility. The ECB in
contrast focuses exclusively on inflation, and as we shall see, this may pose a
challenge for communicating an end to its asset purchases.  

The Great
Graphic
shows the harmonized measure of CPI for the four largest EMU
countries:  Germany (white), Italy (yellow), France (green), Spain (fuchsia).
 
Spain released its preliminary March CPI earlier today.  The
year-over-year pace rose to 1.3% from 1.2%.  The median forecast in the
Bloomberg survey was for a rise to 1.5%.  The preliminary report does not
distinguish core prices, but it is possible that the core rate eased a touch. 
The rise of the headline rate may have been the result of the base effect
related to electricity and gas costs. 

Germany reports its preliminary March on Thursday, followed by France and
Italy on Friday. 
German headline inflation is expected to rise to
1.6% from 1.2%.  France is expected to increase to 1.5% from 1.3%, and
Italy from 0.5% to 0.8%.  

Next week, the eurozone’s preliminary estimate will be reported. 
It is expected to have ticked up to 1.4% from 1.2%, while the core is expected
to have risen to 1.1% from 1.0% where it was in January and February.  It
was last at 1.1% last September, having peaked in April and July 2017 at 1.2%.
If there is disappointment it could be that the core rate was unchanged. 
The headline rise may be traced to energy, food, and non-alcoholic
drinks.  

Also, despite the continued decline in unemployment, labor costs (which
include wages and indirect benefits) rose 1.5% in Q4 17, the weakest in a
three-quarters.
  This is a similar conundrum facing the US and Japan,
where the relative tightness of the labor market is not spurring the increase
in wages that economists project.  

Within EMU, sustained inflation differentials are part of the changing
competitive landscape.
  Lower inflation in Italy, for example, than
Germany, is tantamount for an appreciation of the German euro and the
depreciation of the Italian euro.   

The Federal Reserve could exit its QE, raise interest rates and allow its
balance sheet to begin shrinking despite price pressures remain below target.
 
This is because of the Fed’s dual mandate.  With unemployment (and growth)
exceeding targets (full employment, trend growth) the Fed appeared willing to
accept below target inflation.  

It is more difficult for the ECB with its single mandate to look past
below target inflation
.  Early last year, when headline CPI hit 2.0%,
the ECB simply tapered its bond buying to 60 bln euros from 80 bln.  It
did not judge price pressures to be sustained.  It is possible that even
with a lower level of price pressures, it judges inflation to be more
durable.  However, the rhetorical flourishes needed, especially, if the
weakness in the survey and sentiment indicators over the past three months is
sustained and confirmed by real sector data. 

Two ECB officials Praet and Liikanen have cautioned against premature ECB
tightening. 
Praet is opposed to changing the language on
stimulus.  He expressed surprise by the influx of new workers that could
be suppressing wages and prices.  Liikanen cautioned that price pressures
are lower than expected.  He argued that the case for gradual tightening
of monetary policy is more compelling if ”indications of inflation rates
to potentially temporarily exceed 2% become more prominent in inflation
expectations.”  Bundesbank President Weidmann argued earlier this
week that inflation is predicted to be in line with the ECB’s goal in 2020 and
this alone warrants the start of normalization soon.  

Our concern is that by the time the ECB begins normalizing monetary
policy, the economy would be past its peak.
  This will limit the pace
and extent of the normalization process.  It begins with the deposit rate
at minus 40 bp.  Even if it begins to gradually hike beginning near
the middle of 2019, how much above zero will rates get if growth returns to
trend or lower?  If make some conservative assumptions about Fed policy
with two hikes in the remainder of this year and two next year, peak divergence
still lies ahead. 





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