Andrew Watt Profile picture
Oct 6 23 tweets 7 min read
If policymakers misinterpret #inflation numbers and call for drastic tightening of monetary policy in response, an already difficult economic situation could get infinitely worse.
Here’s why this could be a real risk in the coming months.

The first reason is simple: policymakers need to focus not on current inflation numbers but on rates expected when policy impacts will be felt on the economy, i.e. at least 1 year down the line.
On this see this thread:
Here I want to focus on a 2nd, interrelated reason. It’s a tad more complex and so the thread is quite long, but do stick with it: the results are quite striking!
I'm going to use German numbers to illustrate the points, but the same holds broadly for the Euro Area as a whole.
Let’s start by going back to the “policy lags” argument. A rebuttal might run: But inflation is forecast to be high also in 2023. For 🇩🇪 you could point to the joint forecast (known as “GD”) by 4 leading economic research institutes: 2022 8.4% rising to 8.8% next year.
“Not only is inflation very high. It is set to increase. Vigorous action is needed!“
That finding is intuitively plausible. But wrong! To see why we need to delve a little into the way inflation is reported and the impact of so-called base effects.
The 8.4/8.8% forecasts are annual average changes. A price index shows how much prices have risen each month (since a given starting point). The annual average is the average of the 12 monthly values.

The annual average change is then the % difference between 2 averages.
The blue line shows the way the 🇩🇪 index has increased since the start of 2021. The left-hand black bar shows the 2021 average. The middle one shows the expected average for 2022; we have data up to September and have to forecast the other 3 values. The difference is 8.4%.
Given an annual-average-change forecast of 8.8% for 2023, the average of the 12 monthly index values in 2023 needs to be exactly that much higher than for 2022. In purely mathematical terms, there are many “paths” of the index one can set to generate that outcome (“scenario”).
But economically (I’ll return to this below) the path is constrained to be broadly like that in the graph: the index steadily flattens. But by how much? And what does it mean? To see that we convert the index into 2 other inflation measures, the annual & the monthly rate.
The annual rate is the most familiar, the one with the well-known ECB target of 2% a year. It is the change in the index compared to the same month the previous year.
The monthly rate compares values with the previous month; the implied “target rate” is ~0.17.
Here are the corresponding values for the annual and monthly rates. Shockingly, we see that the very high 2023 average-annual rate, higher than 2022, is readily compatible with an annual inflation rate of 3.8% at end 2023, still above target, but not hugely so, and falling.
Moreover, the monthly rate, the best indicator of price dynamics, could plausibly be already *below* the inflation target already by late 2023.
This is exactly when restrictive monetary (or fiscal) policy now would make their effects felt on prices (and employment).
How can this apparent discrepancy be explained?
Base effects:
Briefly, inflation in the 2nd half of year 1 adds to the annual average, but also pushes up the starting point of year 2’s index. Part of the annual-ave inflation increase for year 2 has already occured in year 1!
If late-year monthly price rises are large, it creates a large “overhang” which means that, for a given annual average, monthly rates in the following year have to be lower. Currently inflation *is* now very high and so the overhang going into 2023 is very substantial.
The annual rate must therefore fall quite markedly in 2023. Still, it takes 12 months for rapid price rises to drop out of the numbers.
The most oft-cited inflation measure, which dominates the policy discourse, is thus to a considerable degree backward-looking.
If attention were paid to the monthly rate it would offer a much better guide to the underlying dynamic (after allowances for data noise). But in practice it is barely present in the debate.

Before concluding, let me anticipate 3 arguments:
It's true that, for a given forecast, the index path is not mechanically determined. But the scope for variation from the one given is limited. You can delay the fall in inflation rates, but then you have to compensate with, probably, negative monthly rates at year’s end.
Conversely, to get higher year-end rates, inflation would need to fall off a cliff in spring.

(In fact the GD includes a graph with forecast quarterly rates (p. 42 of… ) which has a similar form to my scenario.)
Ofc the scenario path depends on the annual-average forecast chosen. The GD might be too optimistic. OTOH it might be too pessimistic. The same exercise based on our @IMKFLASH forecast (7.8%, 5.7%) implies a decent chance of *negative* monthly inflation by end 2023.
Finally, doesn’t this all assume that #ECB doesn’t know what it is doing?
No. Of course ECB understands base effects. But it does not take decisions in a vacuum. Politicians & journalists mostly don’t understand technical issues (or have an interest in misrepresenting them).
& I’ve heard plenty of “serious” economists arguing from current annual inflation rates. These wont fall noticeably until spring. By then the drumbeat of public & supposedly “informed” opinion might well have pushed interest rates higher ensuring a steep(er) recession in 2023.
Ofc there is much uncertainty, esp about the war & energy prices. But our current best guess is that 🇩🇪and €A inflation will *not* be high, but low & falling by the time policy decisions taken now affect it. Any further monetary tightening must be justified against this fact.
While it's certainly sensible to design fiscal policy measures so they raise prices (& energy consumption) as little as possible, efforts to mitigate fuel poverty & sustain real incomes shd also be taken w/ a view to end-2023 inflation being lower than commonly perceived.

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More from @AndrewWattEU

Aug 28
A lot of people have got the idea that marginal pricing and the merit order are to blame for high electricity prices.
They struggle to accept that prices are set by the highest-cost (not average) producer, that gas drives electricity prices despite renewables.
However this is akin to shooting the messenger who brings bad news.
Marginal pricing is actually just the way prices are normally set in competitive markets. Of course prices can be set differently. But then the impacts of other pricing principles need to be considered.
For any homogeneous (no quality differences) good there are different producers with different costs of production. They can be technically more or less efficient or face higher/lower costs for inputs (not least of labour). None can sell goods below its production cost.
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Mar 8
I see a lot of talk of the west "filling #Putin's war chest", "financing the war on #Ukraine", of sanctions “bankrupting” the Russian state etc. Such language points to serious misconceptions. It is important to get some basic economic facts straight.
That’s the aim of this🧵
In all these issues it is vital to keep separate: 1) what involves payment in roubles and what transactions are in, for Russia, foreign currency, and 2) what production is currently/potentially in Russia (or close allies) and what is based in "hostile" countries.
The rouble is a currency that the Russian government/central bank can issue at will. The supply of foreign currency is limited (basically) to past and current exports of goods in excess of imports, factored in or previously converted into foreign currency (€, US$ etc.)
Read 18 tweets
Nov 30, 2021
Excellent reporting @FT on #Pfizer. It is as wrong to demonise as it is to lionise the company, set for revenue of USD 80bn (!) this year. No private co. sd be able to dictate to governments as Pfizer has.
Oddly the article doesn't mention patent waivers.
1/3 Image
I'm sceptical that a patent waiver will quickly resolve shortages in low-income countries, & concerns about longer-run negative effects are serious. But it is the lever to ensure the pharma co.s behave responsibly. e.g. 1:1 #COVAX donation for hi-income-country sales.
2/3 Image
An absolute minimum is that the vax companies have to be more transparent about their order books and sales policies.
There is also the separate but related issue of how and where the revenue streams and profits are taxed.
Read 4 tweets
Nov 25, 2021
It’s out: the coalition agreement of Germany’s traffic-light coalition.…
All of 177 pages covering everything with what to do about Russia to what to do about wolves. (yes, really).
What’s in it for Europe?
Thread (w/ focus on economic issues).
A first point is just how pervasive Europe is. “EU” or “europ” is mentioned no less than 393 times! Scarcely a policy area that does not somehow involve Europe. 🇪🇺 is domestic politics. It is also a testament, tho, to an (ex ante) willingness by 🚦to engage w/ EU partners. 👏
EU structures: 🚦 commits to supporting the Conference on the Future of Europe – including “Treaty amendments where needed”. A right of initiative for the EP, transnational lists and “Spitzenkandidat”, QMV in foreign policy. Steps on a path towards a "European federal state".
3 Image
Read 18 tweets
Jul 5, 2021
As 🇩🇪💉campaign loses some momentum, an anxious question arises: is this due to greater than expected resistence to getting a jab? And will vax rates that could realistically be achieved be enough to limit the public health risks?
@rki_de looks at both Qs & ... is confident
There is a lot of detail in the report, but the key message on needed vax rates - in most cases: 2 shots - is:
90% coverage of the <60's is needed.
For 12-59 year-olds there is a huge difference btwn 65 & 75% coverage. Above that the effect is smaller.
(>12 assumed = 0).
For a baseline scenario (a set of plausible assumptions including seasonality, role of delta etc.) the fig. shows the modelled incidence (cases /100.000pop, 7 days). Above 85% the additional protective effect is marginal. The figure for hospitalsiations has the same form.
Read 9 tweets
Jul 5, 2021
.@SDullien & @KatjaRietzler have a paper out showing the scope for expansionary fiscal policy in Germany if the debt brake - which, stupidly, has constitutional status - were relaxed in various ways.
As this is relevant for the 🇪🇺 debate, a few key takeaways in EN.
Keeping it simple, we'll just look at the total additional nominal fiscal marge de manouvre for the period 2023-30 (without feedback effects) opened up by 5 options.
Setting up a state-owned entity to borrow 1% of GDP for public investment a year would not need a change in the 🇩🇪 constitution. It creates fiscal space of €56bn with unchanged EU fiscal rules. If these are relaxed in the direction of a golden rule, that space quadruples.
Read 7 tweets

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