ECB core obsession raises risk of policy mistake

Tell me how you read inflation and I will tell you who you are.” This clumsy adaptation of a famous quote by German philosopher Martin Heidegger gives an apt summation of the current divide at the European Central Bank.

Headline inflation in the euro zone has halved in the past nine months and was 5.3% in July. But that’s not good enough for ECB hardliners. They want to see the core number, which excludes energy, food, alcohol and tobacco, come down sharply before putting an end to the unprecedented climb in the bloc’s interest rates. That measure is falling more slowly and was running at 5.5% in July.

Joachim Nagel, the president of Germany’s Bundesbank, told the Financial Times in March, after seeing core inflation hit 5.6% the month before, that the underlying measure would have to “decline sufficiently” before the ECB could stop hiking. His sentiments have been backed up by peers like Dutch central bank Governor Klaas Knot.

Granted, both headline and core inflation are currently above the ECB’s 2% target. But the emphasis on the latter is misplaced for two reasons. The first is that core inflation is not a good indicator of where the headline figure is headed, as shown in a 2011 study by economists Lucrezia Reichlin and Michele Lenza, and an ECB bulletin published just last month.

In fact, core tends to follow headline inflation because its narrower composition makes it stickier. That discrepancy has been particularly pronounced in recent years. In late 2021 and early 2022, prices of energy and food, which make up around 30% of the headline inflation index, soared because of a post-pandemic demand spurt, as well as the war in Ukraine. With those pressures now abating – energy prices dropped at an annualised 6.1% in July – the headline number is falling more quickly than core.

The second reason is that headline inflation is a better gauge of consumer expectations, which policymakers monitor closely to ensure they are keeping future price rises in check. That’s because, as the chair of the U.S. Federal Reserve Jerome Powell said recently, headline inflation is “really what the public experiences”. Indeed, the latest ECB survey found that Europeans are responding to recent falls in the headline rate: consumers expected inflation to average 3.4% over the next 12 months, down from 3.9% a month earlier.

With the deposit rate at a record high of 3.75% and a fragile economy, the ECB needs to ensure its anti-inflationary zeal doesn’t plunge the bloc into a recession. ECB President Christine Lagarde has pledged to be “data-dependent”. Looking at the right data would certainly help.

CONTEXT NEWS

Euro zone inflation fell to the lowest level since the beginning of the year in July, but underlying measures of consumer prices are proving stickier, according to the latest data.

Headline inflation rose at an annual rate of 5.3% in July, according to Eurostat, Europe’s statistics agency. However, “core” inflation, which excludes the prices of energy, food, alcohol and tobacco, rose 5.5% year-on-year, not far from the all-time high of 5.7% touched in March. Both gauges are above the European Central Bank’s 2% target. Hardliners such as Joachim Nagel, president of Germany’s Bundesbank, and Klaas Knot, his Dutch counterpart, have argued that the ECB should not halt its rate-hiking campaign until core inflation gets closer to 2%.

Euro zone headline inflation has fallen below core inflation Euro zone headline inflation has fallen below core inflation.
Source: Reuters (Editing by Neil Unmack, Oliver Taslic and Streisand Neto)