Eurozone annual consumer price inflation fell further to 0.4% in July versus 0.7% in January and 1.6% in July 2013. This decline, however, is largely explained by lower energy and food costs. “Core” inflation, i.e. excluding energy, food, alcohol and tobacco, was 0.8% in July versus 0.7% in January and 1.1% in July last year – see first chart.
The modest reduction in core inflation over the past year, moreover, partly reflects a smaller boost from indirect tax rises. Tax rate changes contributed 0.2 percentage points (pp) to CPI inflation in July 2014, down from 0.4 pp a year earlier, according to Eurostat*.
A fall in inflation due to lower imported energy and food costs and smaller tax rises is positive, not negative, for demand and activity, ceteris paribus.
The stabilisation of core inflation since late 2013 is consistent with the “monetarist” rule that price developments echo money supply trends about two years earlier. Annual growth in narrow money M1 bottomed in mid-2011, though recovered significantly only after mid-2012 – second chart. The rule suggests that core inflation will firm through mid-2015. A prior large rise in M1 growth in 2008-09 preceded a faster rise in core prices in 2010-11.
Annual M1 expansion fell back from spring 2013. The ECB cut official rates in November and June and will offer additional liquidity via targeted longer-term repo operations (TLTROs) from next month. It also plans to buy asset-backed securities. Six-month growth in M1 (and M3) recovered between April and June. Launching large-scale QE would probably have limited additional impact on monetary trends, based on experience elsewhere**.
The ECB blundered in 2011, tightening policy when real money was contracting, thereby guaranteeing a recession. It corrected this mistake in 2012 and its current stance is reasonable, assuming a continuation of recent monetary trends.
*These estimates assume 100% pass-through.
**Japanese money growth, for example, is little changed from October 2010 and April 2013, when QE was introduced and expanded respectively – see previous post for more discussion.
