Based on the German inflation print, the ECB may be less ‘hawkish’ next week than people think

Today the German Federal Statistics Office reported that the February Consumer Price Index is expected to mark a 2.0% (2.047% by my calculations, which is very close to a rounded 2.1%) annual pace in February 2011.

This is simply a ‘flash’ print, and the Statistics Office was very careful to discount the fact that inflation continues to be driven by energy. But the harmonised index of German consumer prices (HICP) increased a greater than expected 2.2% over the year, suggesting upward pressure to the headline Eurozone rate remains in play. Market participants are expecting ECB rate hikes this year – there are currently at least 2 hikes priced in through this year – based on an elevated Eurozone inflation rate, currently estimated at 2.4% in January.

The ECB is a devout inflation targeter (see first chart of this post); it’s a central bank that raised rates late in 2008 only to see Eurozone inflation plummet as the economy dropped into recession (see chart below). But I think that the ECB will be less hawkish than expected next week, because I’m noticing an interesting correlation between German-based inflation (supposedly not relevant, per se, to ECB policy), Eurozone HICP inflation (the ECB’s target rate of inflation), and the refi rate.

(Note that the ECB targets a weighted composite of harmonised index of consumer price inflation (HICP), rather than a composite of the domestic price indices. You can read about the measurement differences between domestic CPI and Eurostat’s Harmonised CPI here.)

The chart illustrates the German CPI, the German harmonised measure of the CPI (HICP), Eurozone HICP inflation, and the ECB’s policy rate. There are three things that jump out at me as relevant for ECB policy expectations: (read more after the jump!)

(1) The correlation between Eurozone HICP inflation is stronger with domestic German inflation (CPI) than with the German harmonised measure of inflation: 59% vs 88%, respectively.
(2) Related to number (1), the ECB policy rate appears to be driven more by the domestic measure of German inflation (CPI) rather than its harmonised measure. At least in the 2008 energy bubble, the German harmonised rate of inflation was falling well before the ECB hiked the refi rate.
(3) Therefore, it is possible, that with German CPI printing at a lower rate than the harmonized measure, currently 2.05% vs. 2.23%, market participants who expect a very hawkish ECB statement next week may be disappointed (the ECB announces its policy rate next week).

The exact reason for (1) is worth exploring.

Rebecca Wilder

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