Can Germany save itself from negative rates?

Abstract

German inflation looks set to rise in response to diminishing slack in the economy. But this will be a mixed blessing for those in Germany hit by negative policy rates and ECB asset purchases. Higher German inflation may eliminate the need for further ECB policy action, but it is unlikely to trigger imminent rate hikes. As a result, the rise in inflation will merely lower real interest rates for German savers. Structural cross‐country differences mean that the ECB is better able to hit its inflation target when the peripheral economies rather than Germany are the region's growth engine. A key reason for this is that the German Phillips curve is flat by Eurozone standards, meaning that policymakers need to work hard to generate sufficient inflation in Germany to offset sustained weakness elsewhere. Despite this, there is evidence to suggest that the tightening labour market is beginning to push German wage growth higher. And if productivity growth remains subdued, this will lead to faster unit labour cost growth. While firms could respond by lowering their margins, the strength of household spending suggests that firms may be more inclined than in the past to pass on higher costs to consumers. In all, we expect German inflation to rise more sharply than elsewhere to around 2% in 2017, meaning that the ECB will not unveil further unconventional policy support. But it would take much sharper rises in German wage growth and inflation than in our baseline forecast to prompt the ECB to bring forward interest rate rises.