Inflation in the Eurozone, second quarter 2013. An anomaly?

Eurostat recently published the Eurozone GDP-inflation data, 2013-Q2. They trail the HICP-consumer price inflation index by about two months but they cover a lot more ground: not just household consumption but also government consumption, investments, exports and imports. They show:

(A) rates of inflation which, in the short run are below the ECB  medium run ‘moins de 2%, proche de 2%’ inflation target.   Domestic demand inflation is, as it also contains information on prices of investment goods and services and government purchases, a broader and therewith better inflation metric than consumer price inflation, the rest of this post will abstract from consumer price inflation. Note that though consumer price inflation is the most ‘common’ inflation metric and also the target metric of the ECB the GDP deflator is the inflation index implicit in all kinds of NGDP targets as well as the metric used to calculate ‘Real Unit Labour Costs’ (rule of thumb: subtract labour productivity growth from GDP inflation and you will get the change of Real Unit Labour Costs).

(B) The rate of domestic demand inflation is declining and has been declining for quite some time now (almost two years).

(C) GDP inflation is also still low compared with the ECB target but is, contrary to domestic demand inflation, increasing.

What causes the difference in development between domestic demand inflation and GDP inflation? Does the increase in the rate of change of GDP inflation indicate growing inflationary pressures? No, it doesn’t. At least not for the Eurozone. The difference between domestic demand and GDP demand is of course exports. Below, two graphs are shown, one of the difference between domestic demand inflation and GDP inflation and one of the terms of trade (export prices divided by import prices) – changes in the terms of trade clearly explain the difference between GDP and domestic demand inflation. The increase of GDP inflation does indicate faster price increases for ‘foreign’ companies, governments and households which buy stuff from the Eurozone. But, considering the decline of domestic demand inflation, it does, in this case (!), not indicate faster price increases or higher inflationary pressures for or from Eurozone households, governments and companies.

Aside- terms of trade are of course influenced by, for instance, oil prices but also by the rate of exchange. And a higher rate of exchange will mean higher terms of trade and  therewith also higher Real Unit labour Cost (RULC) increases. Which is another reason why RULC are a very flawed indicator of domestic comeptitiveness.