The ECB would quash a discrete shift in German nominal GDP rather than accommodate it
David Beckworth points to Scott Sumner, who points to Kantoos on the effectiveness of nominal income targeting in Germany. Kantoos’ illustration certainly suggests that the ECB has been successful in getting the dynamics of output and prices (nominal GDP) right over the last decade.
I have no contention with the historical evidence. Whether or not the historical data supports an effective nominal GDP target is trivial compared to the suggestion that the ECB will tolerate a pickup in German nominal GDP going forward. Wage pressures and lower unemployment will lead higher nominal GDP, but will likely increase German inflation as well; this will set the stage for tighter, rather than accommodative, ECB policy.
Although Kantoos did acquiesce that the ECB doesn’t officially target nominal GDP, he didn’t, in my view, give this simple fact enough face time. The ECB is the most hawkish of the G4 central banks. As you can see from the histogram of inflation over the last decade, the central tendency is very strong at 2-2.5%.
As the histogram shows, the ECB rarely institutes a policy rule that drives inflation above its stated objective: “the ECB aims at inflation rates of below, but close to, 2% over the medium term.” The ECB’s reaction-function to German price pressures will be of utmost importance, given Germany’s 26% weight in Eurozone inflation.
Kantoos and David Beckworth posit that the 2% wage growth achieved due to highly competitive German industry (see reference at end of post) is evidence that the ECB targeted nominal GDP and nominal per-capita GDP effectively. In contrast, I would argue that the ECB’s had it pretty easy, where the recession simply delayed the inevitable tightening that would have occurred in favor of the 2% inflation target.
(Read more after the jump)
Measured on a quarterly basis, annual per-capita nominal income growth in Germany averaged just 2.1% since Jan. 1999 (when the ECB took over monetary policy across the Eurozone). Germany represents 26% of the HICP (harmonized price index used by the ECB, and the weighting data is available at Eurostat table prc_hicp_inw), so upward economic pressure on German prices and output (nominal GDP), would manifest into, all else equal (i.e., not offset by deflation in other big countries), average inflation above the ECB’s comfort zone – I use the word ‘zone’ loosely; it’s 2%. The ECB is unlikely to tolerate this.
Currently, tax hikes and a rebound of economic activity and commodity prices are pressuring prices in even the ‘fiscally austere’ European economies (Spain at 2.9% annual inflation in December). So the offset to German inflation pressures on the average inflation rate are not existent at this time.
My sense is that the ECB is biding its time until German price pressures emerge before they have to tighten monetary policy across the Eurozone. For example, the ECB must have been happy that some German unions are negotiating wage hikes that are lower than the current rate of annual per capita nominal GDP growth, 4% Y/Y in Q2 and Q3 2010. (see chart above).
So how much time does the ECB have? At this time, excessive inflation is not ubiquitous in the German HICP, the ECB’s preferred measure of inflation. Currently it really is mostly a food and energy story.
I computed a diffusion index across all of the subcomponents of the HICP index for some Eurozone economies. The index is pretty simple: above 50, there are more components of the HICP that are growing at a greater than 2% annual pace, while below 50, there are more components growth below the 2% pace.
The December diffusion in Germany, 28, is lower than its average since 2004, 33. Not only has Germany historically seen prices growing broadly lower than 2%, but they still are. However, despite the low the level of diffusion, the trend is upward.
As wage contracts reset, I expect that the breadth of price increases will increase and drive overall inflation above the historical German comfort zone, 1.5% average 1995-2007 (before the recession). In the weaker economies, Portugal (not shown), Italy, and Spain, there has been a pickup in subcomponent-level 2% inflation as well – eventually pressures in these economies should fade with fiscal austerity.
However, pressures are in the pipeline. Tight capacity utilization and labor markets will inevitably drive inflation on the cost side.
According to the European Commission, the survey of German Q1 2011 capacity utilization, 84.9%, is above its decade average, 83.1%. Eventually, German firms will have to pay higher wages on the margin in order to satisfy strong(er) demand.
And German labor markets are tight. Schroeder’s labor reform has dropped the unemployment rate, 6.6% in December 2010 on a seasonally-adjusted and harmonised basis, to well below its 15-year average, 8.5%. Inflation from the cost side is certainly in the works, barring a surge in productivity, that is.
In my view, German prices should be allowed to trend upward – the German real exchange rate is too low. If Spain, Italy, Portugal, or Ireland are to have any chance at all for fiscal austerity to actually drop the fiscal deficit, German prices must rise (I’ve written about this before). In my view, though, it’s more likely that the ECB attempts to quash a discrete shift in German nominal income growth via tighter policy than accommodate it.
Reference: The European Commission publishes a quarterly report on Price and Cost Competitiveness, a fantastic resource. Regarding German trends in competitiveness and the real exchange rate, please see the charts for Tables 3, 4, and 5 on page 2-12 (.pdf page 16) in the latest quarterly report on price and cost competitiveness.
US economy hasnt nothing, Europian has Germany, but also Egypt etc near and Island, Greece in.
You make a fairly compelling case that Germany at least (among the Eurozone), is approaching productive capacity. And yet, after two and a half years real GDP in Germany is below peak despite increased labor utilization. How do you reconcile the fact Germany has suffered a decline in productivity over this period with your other observations?
P.S. My concern is that an excessively tight ECB policy is being driven by an unfounded optimism with respect to the state of the German economy.
P.P.S. Shouldn’t ECB policy be more concerned about core inflation? I know they follow headline but should they?
Thanks for your comments, and thank you for stopping by!
First, German GDP is now just 1.4% below its peak in Q1 2008. To your point, the productivity has been a drag; and based on the GDP spending breakdown, we can see why:
Machinery and equipment ivnestment is 13.3% below the cyclical peak
Construction is 3.1% below its cyclical peak.
Heck, even exports are 1.4% below their cyclical peak (near 50% of the economy).
Consumption is the one area (and imports) that have rebounded fully through Q3 2010 ( the spending breakdown is not available for Q4 at this time).
My point is, German factories are adding back workers and hours in lieu of new investment – this is unproductive. It’s showing up in consumption gains, but still meager investment in levels.
Also, my new colleague, Kash, has a very interesting illustration over at his blog, the Street Light. He calculates manufacturing output gains/losses across the major developed markets AND the corresponding unit labor cost gains/losses. Germany is paying on the margin more for increasingly less productive labor (the high growth in unit labor costs) and getting less for it (accumulated loss in industry output).
I will restate this answer on a post. It’s a great point, and I’m glad that you made it here at AB.
You ask: “Shouldn’t ECB policy be more concerned about core inflation?”
The simple answer is, yes, in my view. Headline inflation is much more likely to converge to core, and not the other way around. The ECB is too concerned with pass-through of energy – they were hiking rates in 2008 when the economy turned down the next quarter. They’re too tight, especially for the Periphery.