The ECB May Be Less 'Hawkish

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.

To be sure, given the volatility in energy (and food) prices, there is a tendency for headline inflation to converge to core. Therefore, the ECB should NOT be worried about the headline rate, given the ubiquitous fiscal austerity that will serve as a natural drag on inflation pressures across the Eurozone. But the ECB is a devout inflation targeter, a central bank that raised rates late in 2008 only to see Eurozone inflation plummet as the economy dropped into recession.

So why is the German inflation print important? It’s not the ECB’s preferred measure of inflation, the Harmonised measure of German inflation which serves as 26% of the ECB’s inflation target. But I’m noticing an eerie correlation between German-based inflation, Eurozone HICP 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 the measurement differences between domestic CPI measures and Eurostat’s measure of Harmonised CPI here.)

The chart illustrates the German CPI, the German harmonised measure of the CPI, Eurozone inflation, and the ECB’s policy rate. There are two things that jump out at me:
(1) The correlation between Eurozone 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 is correlated with the domestic measure of German inflation rather than the harmonised measure.
(3) It is possible, that with German CPI printing at a lower rate than the harmonized measure, currencly 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).

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