Stephen Miller
German CPI inflation highest since unification
Provisional March CPI inflation figures for Germany highlight the challenges facing the European Central Bank (ECB) ahead of the broader Euro area CPI release on Friday. Europe is grappling with rising prices at the same time as confronting a likely severe jolt to activity growth as a consequence of elevated energy and other commodity prices in the wake of the Ukraine conflict. Compounding that set of difficulties is the challenge posed by a heavy reliance on Russian-sourced supplies for the bulk of its energy needs.
The March figures show that German CPI inflation increased a whopping 2.5% in March for an annual increase of 7.3%. That annual increase is the highest on record since unification of Germany in 1990. If the historical record were to include West German numbers that result would be the highest since October 1981.
While the March numbers represent the initial impact of the energy price spike in the wake of the Ukraine conflict, inflation had already surprised with its momentum, magnitude and persistence before the conflict erupted. In this sense, and like the US Federal Reserve (the Fed), the challenge for the ECB is one of rectifying the policy mistake of not adjusting its stance soon enough in the wake of enduring inflation pressures, some of which were arguably motivated by the application of a level of monetary stimulus beyond its use-by date.
Challenges writ large for all developed country central banks
Mohamed El-Erian encapsulated well the problem facing developed country central banks. That is, absent a quick reestablishment of their inflation management credentials, central banks – including the Fed and ECB – are confronting a potential no-win policy paradigm that was up until a few months ago entirely avoidable.
This unfortunate sequence, he notes, is painfully familiar to a number of developing countries:
- First, through a misdiagnosis of the economic situation or policy inertia or both, the central bank falls behind inflation realities and erodes its inflation-fighting credibility.
- Second, swallowing its pride, the central bank acknowledges that inflation is too high, toughens up its policy narrative and embarks on the needed measures.
- Third, rather than be reassured by this (albeit late) change, markets run further away from the central bank and signal the need for even more aggressive policy measures.
- Fourth, the central bank finds itself in the dilemma of either risking a recession by validating the ever-more hawkish market pricing or seeking to minimize such damage, often unsuccessfully, by enabling high and potentially more destabilizing inflation to persist even longer.
Now in the realm of “least bad” options
Like the Fed, the ECB finds itself in the realm of already having made a policy mistake. Moreover, as El-Erian notes there is now some question as to whether there is still a prospect of a “first-best” solution. The worry is that the Fed and the ECB are now engaged in the most delicate of central bank high-wire acts. Having let inflationary expectations escape the realm of being within their ability to comfortably manage without a serious risk of a substantial growth dislocation, both central banks are being forced to confront the question of the “least bad” approach. In other words choosing between meeting an inflation target by causing a recession, or allowing high and potentially destabilizing inflation to persist well into 2023.
There is a third scenario where some mix of consequential productivity gains, quick-healing supply chains, surging labour force participation, continued financial market resilience and the deft execution of the high-wire act by the central bank means the economy navigates the challenge and the central bank manages to get out of the deep hole it has dug for itself.
Unfortunately, history is replete with failed central bank attempts at such a high-wire act.
The lessons for the RBA are salutary.
RBA inflation forecasts too low. Policy rate increase in May?
Even if he were tardy in doing so, it is clear that the Reserve Bank of Australia (RBA) Governor, Phillip Lowe, has ditched the “no policy rate increase before 2024” mantra. However, if some of the early indications of March quarter price pressures show up in the March quarter CPI release on 27 April, the next Lowe nostrum to be retired will be the “Australia is different when it comes to inflation” mantra and with it, the existing RBA commitment to “patience” in raising the policy rate.
That latter notion that the inflation picture was somehow that different in Australia was never wholly convincing. Of course, the Australian economy is different from other developed economies (not least in its exposure to China), but not sufficiently so that the same laws of supply and demand and their effect on prices do not apply here. Australia is an example of what the textbooks term a ‘small-medium open’ economy. By definition, such economies are ‘price-takers’ with that ‘price’ determined by global forces. Accelerating global inflation – other things equal – means accelerating Australian inflation.
RBA Governor, Philip Lowe, has referenced “increasing globalisation” as keeping a lid on prices. Leaving aside the question as to why “increasing globalisation” has an outsize impact on Australia, the fact is that the political currents are running the other way with a populist backlash against globalisation of markets seeing increasing protectionism, along with increasingly more activist domestic regulatory agendas. This will lead to heightened upward pressure on business costs and prices.
On the labour market the Governor made much of so-called “wage inertia”. The thinking appeared to go that the maintenance of a relatively high participation rate due to measures such as Job-Keeper means wage growth may be more relatively subdued. It might just as easily be argued that a lower pool of ‘discouraged’ workers in Australia means more proximate wage acceleration here than elsewhere. The “inertia”, if it exists, is as much a reflection of the particular idiosyncrasies of the Wage Price Index measure upon which the RBA has had (until recently) too much of a singular focus. Abounding anecdotes of labour shortages inevitably mean wage rises. As it should in the current circumstances, the balance of power in the wage bargaining space is increasingly shifting toward labour and that will show up in broader labour cost measures.
The notion of “transitory” inflation is that it doesn’t change wage and price setting behaviour. But there is growing evidence that these behaviours are changing locally as they have elsewhere: companies feel more confident to increase prices because prices are going up everywhere while workers are naturally seeking higher wages in those areas of the economy where skill shortages are acute. In this way, by failing to incorporate supply shocks in its monetary policy framework the RBA, like other central banks, magnifies and perpetuates the inflationary damage such shocks can inflict.
The potential challenge from inflation is illustrated by the latest forecasts from NAB economists of the March quarter CPI. NAB forecasts core trimmed mean inflation at a whopping 1.2% for the quarter and 3.4% over the year. If realised, the six-month annualised rate of core inflation would be 4.4%. Bear in mind, this is even before the full extent of the price pressures unleashed by the Ukraine conflict have been reflected.
An outcome close to the NAB would again blow out of the water the RBA’s Quarterly Statement on Monetary Policy (SoMP) forecasts made just last month in February. The RBA had forecast a peak in core inflation of around 3.25% by mid‑year, which implies quarterly prints of around 0.7-0.8% per quarter. The NAB forecast of 1.2% in the March quarter is significantly higher and by mid-year core inflation will be well out of the 2-3% band at closer to 4.0% on an annual basis.
The March Board Minutes suggested risks were “skewed to the upside” for wages and the risks of waiting too long are rising given reports of firms being “increasingly prepared to pass these higher costs onto their customers.” In other words, inflation is no longer “transitory”.
The NAB forecasts, if realised, intensifies the risk of waiting too long; being too “patient”.
The RBA must by now be keenly aware of this. Expect maximum optionality in the Governor’s April Statement following the Board meeting on 5 April. This means retiring “patience” and foreshadowing a May rate rise.
US non-farm payrolls. ADP employment data as expected
Market expectations for US February non-farm payrolls are for an increase in employment of around 475,000 (from 678,000 in February) and a one-tenth decline in the unemployment rate to 3.7% from 3.8%. The March private payroll data from ADP issued overnight showed an increase of 455,000 versus +450,000 expected, although they are at best only a loose guide to the Bureau of Labor Statistics report. Friday’s report is potentially difficult to interpret as any disappointment in jobs growth may have as much to do with supply-side issues as with any deficiency of demand.
Recent ISM manufacturing reports on note that businesses continue to report labour supply constraints which may have account for any headline employment ‘weakness’. That notion is lent support both by the near record number of vacancies (circa 11.3 million), as well as ‘quit’ rates close to record highs, reported by the US Labor Department’s most recent February Job Openings and Labor Turnover (JOLT) Survey released on Tuesday.
Anecdotal reports of stronger wage growth and greater than expected increase in average earnings in recent months, indicate that wage inflation has certainly taken root in the US and is consistent with tight labour markets. The average earnings number within the overall non-farm payrolls report will likely therefore be closely watched, with the market expecting an annual increase around 5.5%.
The March ISM report is also released on Friday with the key focus on evidence of the effect of supply chain blockages post the Russian invasion of Ukraine, particularly on the prices paid component.
The forgoing follow the release of the February core PCE on Thursday. This is the Fed’s favoured inflation measure. There shouldn’t be a big surprise from the current market expectation of an outcome of 5.5%. The Fed recently revised its forecast for the core PCE up to 4.1% for 2022 from the 2.7% it had been forecasting back in December 2021.