Home > Uncategorized > The ECB and inflation: still looking at only a part of the economy

The ECB and inflation: still looking at only a part of the economy

Inflation in the Eurozone is lower than the ECB states it is. Which means that monetary policy is tighter than the ECB assumes. We just have to look at the right prices to see this. Wages are a price, too. When we look at the economy using the lens of the national accounts (income approach) they even are the most important income related price. When we look at the economy from the expenditure side of the national accounts, consumer prices are of course important. But so are prices of government consumption. And prices of exports and investments. Sales of existing houses are not covered by the national accounts (except for fees of real estate brokers and the like) but house prices also are one of the most important price of the entire economy, and (looking at the long run) increasingly so as in many countries home ownership has increased quite a bit, after about 1930. Only a limited amount of these prices are covered by the ECB’s inflation metric of choice, the HICP index of consumer prices. Which would not be to bad when these prices all showed the same development. But they don’t.

The focus of the ECB on just this inflation metric has cost us dearly. In the period up to 2008 the clearly neurotic attention to the HICP and a neglect of other prices led the ECB to miss out on the house price bubbles in the Netherlands, Spain, Ireland, Slovenia and a bunch of other countries. At this moment we are paying the price for this mayor policy mistake.

Alas, the ECB has not learned from its mistakes. They are still paying neurotic attention to HICP inflation, while missing out on other important inflation metrics which makes them misunderstand the situation. In the annual report the ECB states:

“Annual inflation remained at elevated levels in 2012 despite the unfavourable macroeconomic environment,
although it declined in the course of the year.”


“HICP inflation stood at elevated levels above 2% throughout 2012, declining from 2.7% at the beginning of the year to 2.2% in November and December. The average rate for the year as a whole was 2.5%, which was only slightly lower than the rate of 2.7% registered in 2011. Persistently elevated inflation in 2012 mainly reflected high energy prices and increases in indirect taxes owing to the ongoing need for fiscal consolidation. Medium and long-term inflation expectations remained firmly anchored at levels consistent with the Governing Council’s aim of keeping inflation rates below, but close to, 2% in the medium term.

This is a distorted view of the inflation situation.  Other inflation metrics which show another side of the economy all increased less than consumer prices. Prices of investments, exports, and government expenditure increased less (graph 1). Hourly wages also increased less (graph 2, remember that these prices contain a ‘quality improvement’ in the sense that with some exceptions (government services in the UK or the entire Italian economy in the times of Berlusconi) productivity of one hour of labor tends to increase. And average house prices even declined. For a little meta see below the graphs. All data: Eurostat. Which is important to notice: the method explained below is the same method which leads Eurostat to assemble and calculate all these prices.


Graph 2. Change of average hourly wages (%, YoY), Euro area and EU.

Graph 3. Change of average house prices (% , YoY). Notice high inflation in 2006 – and deflation in 2012.

The ECB people are not dumb (the do use the GDP deflator to deflate export prices in the annual report) and supposedly write this down to convince the public that they are taking inflation serious: hey, look, we believe in Santa Claus too. And indeed, there is ample evidence that our experience of inflation is influenced not so much by the price of investments or exports but by frequent out of pocket expenses. And in the weird world of rational expectations models this means that you have to target something which is close to this daily experience of people. But we’re not living in a rational expectations world. We’re living in a debt deflation world.

Aside: this solves (a small) part of the Cowen-conundrum, i.e. the question why the Eurozone does not have outright deflation, at the moment. At the same time, looking at the GDP deflator is of course much more consistent with NGDP targeting than just looking at consumer prices. Greece is experiencing accelerating deflation at the moment, by the way.

Meta: these prices?

(1) The most basic formula of macro-economics is: Y=C+I+G+Ex-IM. Or: Income is equal to final expenditure (Consumption, Investments, Government expenditure (not counting transfer incomes), Exports).

(2) Y is (simplified) equal to W+P (Wages plus Profits, including ‘mixed income’ of the self-employed).

(3) Consumption is equal to (prices*amounts).  Except for profits the same holds for all the other variables, including the price of the labor of self-employed people. Let’s call the average hourly price of this labor P’.

(4) At the same time, ‘intermediate expenses’ like the purchase of fertilizer by a farmer are left out of this formula, to avoid double counting.

(5) However – these intermediate expenses are paid, with money.

(6) Also, buying something abroad (imports) does not add to ‘value added’ – but money is used to do this.

(7) Now, let’s throw in the MV = PT formula: Money times Velocity (the number of times that a Euro per year is used to pay something) equals the total amount of payments (average price * transactions)

(8) This means that PT = C+I+G+Ex+ (!) Im+W+P’+intermediate expenditure (including sales of existing houses)

(9) Because of a variety of reasons the price levels of each of these sub-markets do not move in tandem, surely not in the short run but also not in the medium and even the long run (houses!)

(10) Tracking inflation therefore means: tracking price movements in all these different markets.

(11) And we are doing this!  The Eurostat data base contains all of these data.

(12) A more complete overview of inflation should therefore look at all of these metrics. The ECB does not do this. Or at least does not tell us that it does this.

  1. bongmendoza
    April 25, 2013 at 9:57 pm

    Reblogged this on bong mendoza's blog.

  2. Jan Milch
    April 26, 2013 at 3:55 pm

    For those interested ,a new,as fare as i see a very welldone study on Europe-Eurozone (no R-R errors!)
    Independent Annual Growth Survey
    First Report from iAGS
    2013 at:

    Click to access 4121_EN_iAGS_Report_version%20finale.pdf

  3. Allen
    April 29, 2013 at 12:54 am

    US and NZ include house prices and rent in headline inflation.EU doesn’t? Even if you do include housing there need to be other tools than interest rates to prevent housing bubbles.e.g. capital gains tax or control’s on lending so that price paid does not exceed reasonable rental earning capacity given current incomes. (Steve Keen’s idea)

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