The annual change in Eurozone consumer prices dropped to -0.2% in December from 0.3% in November, with the negative reading reflecting falls in energy and unprocessed food prices. Excluding these categories, prices rose by an annual 0.7%, unchanged from November. A narrower “core” inflation measure excluding energy, food, alcohol and tobacco firmed to 0.8%, above its level at end-2013 – see first chart.
Core inflation is unacceptably weak but the ECB has already reacted, cutting official rates in June and September, offering cheap long-term funding for bank lending and embarking on QE focused on private-sector securities. Monetary policy affects the economy with a six to 12 month lag and inflation after about two years. Monetary trends provide early evidence about its effectiveness. Six-month growth in Eurozone narrow money M1 rose from 4.1% annualised in May, before the ECB’s first rate cut, to 9.9% in November. Broad money M3 growth increased from 1.0% to 5.3% over the same period. The euro’s effective exchange rate, meanwhile, has fallen by 4% since mid-2014.
The economic definition of “deflation” is a pervasive and persistent decline in prices associated with sustained money and credit weakness. The Eurozone isn’t in deflation currently and the risk of it entering such a scenario has diminished.
German releases today were encouraging, with the level of unemployment falling to a 23-year low in December, unfilled vacancies at a new record and retail sales volume rising by a solid 1.0% in November (although monthly changes are notoriously volatile). The German economy is effectively at full employment: the unemployment rate stood at 5.0% in November versus 5.8% in the US and 6.0% in the UK in the three months to October – second chart.
A major weakness of the official consumer prices index (CPI) is its omission of owner occupiers’ housing costs. The Office for National Statistics (ONS) publishes a companion measure, CPIH, incorporating such costs using the “rental equivalence” method, which imputes rents on owned homes based on those paid on similar properties in the rented sector. The European Commission, however, has decided to base future changes in its harmonised CPI system on the alternative “net acquisitions” method, which measures the costs of purchasing and maintaining a home. The ONS recently started publishing an owner occupiers' costs series using this method. As explained below, an inflation measure incorporating this series would have provided better signals for policy-makers than CPI or CPIH in recent years.
The first chart shows quarterly data for annual CPI and CPIH inflation since 2006. The latter has been consistently slightly lower because imputed rents are estimated by the ONS to have risen more slowly than the CPI*. The difference has averaged only 0.2 percentage points, however, so monetary policy would probably have been the same if the MPC had focused on CPIH instead of CPI inflation.
The second chart compares CPIH inflation with an alternative housing-inclusive measure incorporating the new ONS owner occupiers’ costs series based on the net acquisitions approach**. The latter series gives a significant weight – currently 26% – to house prices. The alternative measure was higher than CPI / CPIH inflation in 2006-07, lower in late 2008 and 2009, and higher again in 2010 and early 2011. A focus on this measure, in other words, would have encouraged tighter policy in 2006-07, when monetary / credit conditions were excessively loose, while suggesting greater room for easing in late 2008 as the recession was gathering pace – the MPC delayed the launch of QE until March 2009.
The alternative measure would have made a stronger case for withdrawing some policy stimulus in 2010, a change that would have tempered the 2011 inflation spike. The MPC, however, might have chosen to ignore the signal because of concern about the growth impact of the pre-announced January 2011 VAT rise and worsening Eurozone economic conditions.
The alternative measure is giving a less dovish message than CPI / CPIH inflation currently, standing at 1.8% in the third quarter of 2014 (the latest available figure) versus 1.4% in both cases. Indeed, “core” inflation (i.e. excluding energy, food, alcohol and tobacco) on the alternative basis was 2.1% in the third quarter – third chart. Reflecting recent house price strength, owner occupiers’ costs rose by an annual 4.1% in the third quarter using the net acquisitions approach versus only 1.0% on a rental equivalence basis.
*The ONS plans to implement methodological “improvements” that will raise its historical and current estimates of rental inflation. The “National Statistics” status of CPIH was temporarily withdrawn in August 2013 pending these changes.
**The alternative measure was calculated by substituting the net acquisitions series for the rental equivalence series in CPIH while maintaining the same basket weight (currently 16%).
Eurozone monetary trends are sending an increasingly positive message for economic prospects. The narrow M1 and broad M3 aggregates posted further chunky monthly gains of 1.2% and 0.7% respectively in November. Six-month growth of real M1 and M3 (i.e. deflated by seasonally-adjusted consumer prices) rose to 4.7% and 2.5% (not annualised), the fastest since 2010 and 2009 – see first chart. This pick-up reflects faster nominal monetary expansion not falling prices – the CPI edged up by 0.1% in the six months to November.
The six-month real M1 change is an excellent leading indicator of the economy: it turned negative ahead of the 2008-09 and 2011-12 recessions, resuming growth before the intervening and subsequent recoveries. The current strong pace of expansion suggests upside risk to the consensus forecast of Eurozone GDP growth of 1.1% in 2015. Real M1 is now rising more rapidly than in the UK in early 2013, ahead of major positive growth surprise.
M1 has probably been boosted by interest rate declines and an associated rise in spending intentions, reflected in an increased transactions demand for money. M3 is more supply-driven: growth continues to be supported by a large balance of payments surplus*, while bank lending to government has picked up (partly in response to the TLTROs), outflows from longer-term savings instruments into deposits have increased and private sector credit contraction has slowed – adjusted for sales and securitisation, bank loans to non-government residents rose marginally in the latest three months.
The ECB publishes a country breakdown of overnight deposits, comprising about 80% of Eurozone M1. The pick-up in Eurozone six-month real deposit growth has been driven by the periphery (i.e. Italy, Spain, Greece, Ireland and Portugal) – second chart. Of the big four economies, growth remains strongest in Spain but is now significantly higher in France and Italy than Germany – third chart.
*Basic balance, i.e. current account plus net direct / portfolio investment flows.
UK GDP and services output figures released today suggest that the economy continues to grow robustly, contradicting widespread expectations of a second-half slowdown – see previous post. Downward revisions to earlier data, however, imply that productivity performance has been even weaker than thought, while indications of a rise in domestically-generated inflation have been confirmed.
The quarterly rise in GDP in the third quarter was left unrevised at 0.7% but “core” growth excluding the volatile oil and gas production sector was revised up to 0.8%. The economy started the fourth quarter solidly, with monthly output data covering services, industry and construction implying that GDP in October was 0.5% above its third-quarter level – see first chart. Quarterly growth, in other words, is on course to reach 0.7%-0.8% if GDP increases by 0.25% in November and December, in line with the year-to-date monthly average.
The main surprise in the GDP release was a significant downward revision to earlier growth estimates, resulting in a cut in the annual GDP increase in the third quarter from 3.0% to 2.6%. Aggregate hours worked in the economy rose by 2.2% in the year to the third quarter, so GDP per hour grew by only 0.4%. The MPC, by contrast, had expected an increase of 1.25%, according to this month’s minutes (see paragraph 23).
Continued productivity weakness has contributed to a rise in domestically-generated inflation. The deflator for “gross value added at basic prices” – a measure of prices of domestically-produced goods and services – increased by 2.4% in the year to the third quarter, revised up from 2.3%. Other GDP price measures cited by MPC member Kristin Forbes in an October speech as relevant for monitoring domestic inflation are rising more strongly – second chart.
The MPC’s dovish majority has counted on a slow recovery in pay growth being partially offset by a recovery in productivity expansion. The earnings pick-up, however, appears to be occurring sooner than expected – see previous post – while tentative signs of a productivity revival have been revised away. The MPC’s leading dove, Mark Carney, is likely to shift focus to other reasons for keeping interest rates on hold, such as the supposed risk of current artificially-low headline consumer price inflation “destabilising” inflationary expectations.
In further disappointing news, the current account deficit widened to a new cash record in the third quarter, with the ratio to GDP equalling the series high of 6.0% reached in the third quarter of 2013. The rise was driven by a further widening of the investment income deficit; the goods and services shortfall, by contrast, remains moderate and stable – third chart.
Paul Krugman recently drew a parallel between the Federal Reserve’s plans to raise interest rates in 2015 and the ECB’s ill-fated 2011 policy tightening, which was swiftly followed by a recession. The monetary context is different, however, casting serious doubt on the comparison.
Former ECB President Jean-Claude Trichet bears the unfortunate distinction of having raised rates on two separate occasions in the teeth of an oncoming recession – August 2008 and April / July 2011 (a double increase). These decisions were astonishing from a monetarist perspective because they were taken against the backdrop of a contracting real (i.e. inflation-adjusted) money supply, as measured by the narrow M1 aggregate – see chart. The associated recessions, in other words, would have occurred anyway but were certainly magnified by the ECB’s actions.
US real M1 growth has fallen back since mid-2014 but remains at a respectable level. A pick-up around end-2013 signalled economic strength in mid-2014 – GDP is currently estimated to have grown at a 4.2% annualised rate in the second and third quarters, although this partly reflects payback for a weak start to the year. The recent real M1 slowdown may herald a moderation in GDP expansion to a 2-3% pace. Monetary trends would need to weaken significantly further to suggest economic danger from a small interest rate rise.
Professor Krugman’s worries, therefore, are premature. The ECB, meanwhile, may be repeating its 2008 / 2011 mistakes in reverse, with President Draghi and his allies seemingly determined to push through sovereign QE in early 2015 despite recent strong monetary growth and building evidence of an economic upswing.