The June increase in German inflation comes at a time of market nervousness about ECB tapering. Fears of a hawkish ECB, however, are clearly overdone.
Based on the results of six regional states, German headline inflation increased somewhat unexpectedly to 1.6% YoY in June, from 1.4% YoY in May. On the month, German prices increased by 0.2% MoM. Based on the harmonised European definition (HICP), and more relevant for ECB policy making, headline inflation increased, to 1.5% YoY, from 1.3% in May.
Looking at the available components at the regional levels shows that the drop in headline inflation was mainly driven by lower energy prices, the continued decline in communication costs and lower prices for services. At the same time, the timing of public holidays pushed up leisure costs. Looking ahead, lower oil prices and the stronger euro exchange rate should lower headline inflation in the coming months.
Today’s German inflation data provides further evidence for the ECB’s (and other central banks’) current dilemma: a cyclical upswing without significant inflationary pressure. If even an economy which has just entered its ninth year of economic expansion and which has record high employment does hardly shows any inflationary pressures, how could the Eurozone as a whole do so any time soon?
Over the last 48 hours, financial markets have been overly excited about the ECB and possible tapering. Looking back at the now famous Sintra speech of ECB president Draghi confirms our earlier view that the ECB has not drastically changed its stance, neither its own take on the economy or the future path of monetary policy. However, the ECB is simply acknowledging its own dilemma of a cyclical upswing which is not (yet) producing inflationary pressure. In our view the reasons for continued low inflation are both: transitory and structural. While lower oil prices, even a stronger euro but also factors like downward pressure on prices due to higher transparency and competitions through digitalization could be labelled as transitory, downward pressure on wages, stemming from globalization, automation or slack could however almost be labelled as structural. Low inflation will in our view not prevent the ECB from tapering next year. Bond scarcity and stronger growth will be the drivers behind such a decision. At the same time, however, the ECB could face the awkward situation in September that due to lower oil prices and the stronger euro its own official inflation projections at the time of a tapering announcement are almost identical with the inflation projections at the time of the QE announcement.
All of this means that the ECB will strike a very cautious balance between moving towards tapering, without jumping the gun and distorting markets. This week’s market reaction has been a clear reminder for the ECB that steering market expectations is an extremely tough job to do.