German Fiscal Measures to Impact Inflation

Germany is one of the most proactive countries that stepped-up fiscal spending to meet coronavirus challenges. So far, it announced two impressive fiscal-stimulus packages – the last one, in early June, was worth almost 4% of the GDP, and aims to support consumers and corporate entities.

One of the components of the last fiscal package involves a temporary cut in the VAT rate – from 19% to 16% for a period of six months only. With the VAT cut, the German state aims at supporting consumption – and it will probably succeed. However, the side effect is that the VAT cut will send inflation on a roller coaster, as such cuts are usually passed to consumers straight away.

Upward Pressure on Inflation Expectations

One of the main side effects is that inflation reacts differently in the short and medium-term. The cut in the VAT rate will immediately send current inflation lower. This is something the ECB does not want to see, as the coronavirus pandemic hit the developed world with a deflationary wave. Moreover, the fall in oil prices (i.e., at one point in April the WTI oil futures settled at -$40) further accentuated the deflationary curve.

Because the ECB is already at the lower end with the interest rates (i.e., the negative rate on the deposit facility and barely positive on the refinancing and marginal lending facility), there is not much room for manoeuvring from an official rate perspective. In the short term, however, lower inflation created by the German VAT cut will cause a headache for the ECB and the Euro. After all, the German economy is the largest in the Euro area, and what happens there acts as a bellwether for other economies too.

Because inflation is mostly controlled by inflation expectations two years from the present times, lower inflation in Germany may send a negative signal regarding inflation expectations throughout Europe. If the consumers and businesses believe that the ECB will not be able to meet its inflation-targeting framework of 2%, the common currency will be hurt. Therefore, a simple fiscal package from one single country part of the Eurozone is enough to create macroeconomic problems for the entire area.

The policy move is a surprise, as the degree to which German businesses will pass through the VAT cut to consumers in the second half of the year is highly unknown. The good part, of course, is that traditionally, huge fiscal stimulus packages lead to upward pressure on inflation and inflation expectations on the medium to long term.

In other words, the ECB may view any drop in German inflation as temporary and will focus on inflation expectations. Which seems like the right thing to do!

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