One Swallow Doesn’t Make A Summer

Today Eurostat announced that the Euro area’s inflation rate (as measured by the HICP) has reached two per cent in February (see press release here: http://ec.europa.eu/eurostat/documents/2995521/7895720/2-02032017-CP-EN.pdf/97184273-b9ae-46e6-99be-e50321ce5fa8). While seems finally some good news for the crisis-battered Euro area, it actually isn’t. Here’s why.

First, have a closer look at the very first chart in Eurostat’s press release:

Euro area annual inflation rate (in %). Source: Eurostat
Euro area annual inflation rate (in %). Source: Eurostat

Hoo boy, that nice inflation comes from energy prices, mostly due to oil price hikes, i.e. it is imported inflation, which is a pretty bad gauge for the overall state of the European economy. In fact the two numbers that give more away about our economy are the last two in this chart. And prices virtually didn’t rise for industrial goods and only a bit more that by one percent for services. Judging from these numbers, there is still some considerable slack in the economy, i.e. we are still producing below capacity. Given the terrible unemployment figures in Italy, Spain and Greece, there should be little incentive for the ECB to even signal a hint of tightening monetary policy, yet this is what politicians and the public (especially in Germany) will do.

Unemplyoment rates (EU-28) (seasonally adjusted). Source: Eurostat
Unemplyoment rates (EU-28) (seasonally adjusted). Source: Eurostat

As a result there will be more tension between the ECB’s policy, its mandate and the public’s opinion, but it becomes harder and harder for the ECB to claim “inflation stabilisation within our mandate” as the reason for doing things like negative interest rates or QE. On the face of it, the ECB has now fulfilled its mandate of bringing inflation back to where it should be, so there should be some hint of tightening. But this is only because the ECB gave itself the wrong measure, by using the HICP as the central inflation gauge.

The HICP is the wrong measure

This illustrates nicely the problem, that the HICP as a policy-relevant measurement of inflation is not up to the task, as I have argued before. The HICP measures consumer prices, not slack in the economy. Worse, consumer prices can only be influenced via monetary policy so far, since it includes by definition import prices over which the ECB has no influence whatsoever. If we want our central bank to smooth the business cycle, the ECB should ditch the HICP target in favour of something that actually captures slack better, e.g. the GDP deflator or maybe a producer price index. Maybe combined with the unemployment rate, as the Fed does it. However, let me stress that a central bank can (at least in the long run) only influence nominal magnitudes, i.e. prices. Real magnitudes (jobs, production) should be the matter of fiscal policy. A central bank that worries about prices and financial stability (as it should), may want to look at different indicators, e.g. the money stock or the amount of credit.

ECB Key economic indicators (http://www.ecb.europa.eu/stats/html/index.en.html, retrieved March 2, 2017)
ECB Key economic indicators (http://www.ecb.europa.eu/stats/html/index.en.html, retrieved March 2, 2017)

The latter, usually a pretty good proxy for the state of the economy, is down by the way. The M3 money aggregate fell in February. Given that QE is still in place and thus ever-expanding the monetary base, the amount of credit created from the base has decreased. So much for the swallow.

 

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Benjamin

I write about economics and politics. I take Ordnungspolitik seriously. While not blogging, I study monetary unions for my doctorate.

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