Carsten Brzeski's blog

Germany: Feeding doves

The May drop in German headline inflation should be another reminder that the current cyclical upswing in the Eurozone takes place without inflationary pressure.

Based on the results of six regional states, German headline inflation dropped to 1.5% YoY in May, from 2.0% YoY in April. On the month, German prices decreased by 0.2% MoM. Based on the harmonised European definition (HICP), and more relevant for ECB policy making, headline inflation even dropped further, to 1.4% YoY, from 2.0% in April.

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 a reversal of the Eastern-related price increase in vacation trips.

Today’s German inflation data should take further pressure off the ECB to wind down its monetary stimulus. The data actually shows that the current cyclical upswing in the Eurozone does not (yet) coincide with a pick-up in inflation. Goldilocks or not, if even an economy which has just entered its ninth year of economic expansion and which has record high employment does not show any inflationary pressures, how could the Eurozone as a whole do so any time soon?

Going forward, the single most important variable for the ECB to decide on significant policy changes will be wages. Draghi has repeatedly called them the ECB’s lynchpin. The German experience, with nominal wage increases of a decent 2% to 3%, but also the US example, with low wage increases despite unemployment rates of around 5%, both show that it can take a while before wage development in the Eurozone will signal an ECB policy move. On top of domestic factors like ageing, still high unemployment and negative output gaps, broader factors like digitalisaton and globalization should continue inserting disinflationary pressure on the Eurozone.

All of this means that the ECB will be in no rush to drastically change its current policy stance. Yesterday, ECB president Draghi already set the tone for next week’s ECB meeting. It should be a meeting which will deliver some important tweaks in the communication, as for example the balance of risks and forward guidance, gently preparing the grounds for 2018 tapering. However, preparing for something and actually doing it are two different worlds in the current ECB universe.