Thursday, January 15, 2009

Relative European Inflation Movements

In line with the preliminary estimate, euro area consumer price inflation fell from 2.1% in November to 1.6% in December, a decline which together with the low level of money supply growth and the economic contraction in the euro area helped push a reluctant ECB to another interest rate cut today.

What is interesting is the movement of relative inflation within the euro area. Holland which for years have had the lowest inflation rate within the euro area, had an inflation rate above the euro area average for the first time in a long time. By contrast Spain, who have had above average inflation for almost the entire existence of the euro, now for the first time saw its inflation below the average. While the euro area average fell from 3.6% in September to 1.6% in December, Spain saw a much larger decline, from 4.6% to 1.5%.

This is similar to how Ireland who also for a long time had above average inflation, previously this year saw its inflation rate fall below the average, something which I discussed in the post "The Irish-Spanish Divergence". But at that time, Spanish inflation remained stubbornly high, something which I thought was puzzling given the Spanish housing bust, but thought was most likely due to the continued high level of immigration. But since then, the Spanish economic contraction has gotten a lot worse while Spanish authorities have taken a lot tougher stance against immigrants, both likely contributing to a radical reduction in immigration. Fewer immigrants may in the short-term (given inflexible wages) limit the increase in unemployment, but it will also further reduce demand for housing, and so aggravate the housing bust.

Another country with particularly large declines in inflation is Luxembourg and also Estonia and Latvia (though the 12 month increases are still well above average for them). Luxembourg is hard hit by the crisis not so much because of a housing bubble, but because it is more dependent than any other country on the crisis struck financial sector. This illustrates that within a monetary union, or between countries with fixed exchange rates, price inflation will be highly correlated with real economic growth. This is part due to the Balassa-Samuelsson effect and in part due to the fact that credit and therefore also money tends to move from relatively weak to relatively strong regions.

By contrast, no similar mechanism exist with floating exchange rates, as low growth countries often experience lower interest rates and currency depreciation, something which fuels price inflation. One good example of this is the U.K. which has seen its inflation rate rise from below euro area average to well above it, as the pound has fallen sharply against the euro. Another example is Iceland, which despite facing the most severe slump of any European country has seen its inflation rate rise from an already high 15.4% to 21%.


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