Summary of the April Monthly Report

The Phillips curve as an instrument for analysing prices and forecasting inflation in Germany

Since the beginning of the financial crisis in summer 2007, it has become a particularly challenging endeavour to analyse and forecast price developments. In Germany, as in most of the other large industrial countries, the inflation rate fell considerably during the Great Recession. Once the economy rebounded, inflation went up again rather quickly until the end of 2011; in 2012, it fell noticeably again and has remained surprisingly low amidst the positive developments in the labour market.

The article in the Monthly Report of April 2016 examines whether inflation developments in Germany over the past few years can be understood in the context of the Phillips curve, according to which there should be a positive relationship between the domestic inflation rate and capacity utilisation in the real economy and/or the labour market situation. The impact of the strong fluctuations in crude oil prices and food raw materials on consumer prices since 2007, too, is taken into consideration. The Phillips curve turns out to be quite good at explaining both the development of the headline inflation rate and what is often referred to as the core inflation rate (ie headline inflation minus energy and food).

However, the results suggest that, since 2009, core inflation has been significantly shaped by fluctuations in import prices (excluding energy), whereas headline inflation was predominantly affected by oil prices. Although the determinants of real economic activity, ie capacity utilisation and the labour market situation, have made a positive contribution to the inflation rate excluding energy and food since 2012, their impact is relatively low and, in many cases, not statistically significant. For headline inflation, the contribution made by the determinants of real economic activity, which goes beyond the impact implicitly contained in inflation expectations, was practically negligible according to estimates. In recent years, this is likely to have been attributable, amongst other things, to the fact that the output gap has virtually been closed since 2012.

There appears to have been no substantial change in the Phillips curve relationship in the case of Germany; merely the impact of external conditions seems to have increased somewhat since 2012. Regarding the forecasting quality of the Phillips curve, the results are mixed. If it is realistically assumed that the path of the explanatory variables is unknown for the forecasting horizon, it would be possible to understand the general direction of the core inflation rate since 2008; however, the innumerable Phillips curve forecasts do not always reflect actual price movements. The result for the headline inflation rate is worse and can be attributed to the dominant influence of crude oil prices.

Stock market valuations – basic theory and enhancing the metrics

With stock market volatility high, the focus of public debate has recently returned to the question of what valuation level is appropriate. Developments in stock market valuations are also of interest from a monetary policy and financial stability angle.

Dividend discount models, which are based on interest rates and dividend expectations and allow the implied cost of equity and equity risk premiums to be derived, provide a theoretical basis for an appropriate valuation. Essentially, these models attribute movements observed in equity prices to changes in the individual model components. However, by providing the implied cost of equity and equity risk premiums, dividend discount models deliver more than just a gauge for stock market valuations and market players' attitude to risk. Developments in individual model components also help assess the broader economic environment for corporates.

In an article devoted to this subject, the Bundesbank's April 2016 Monthly Report takes the usual valuation approaches one step further by focusing on maturity-specific interest rates and analyst dividend expectations. As measured by the implied cost of equity, the DAX's valuation was slightly below its ten-year mean at the end of March. By contrast, the equity risk premium was comparatively high, at 7½%, and close to the implied cost of equity. The small gap between these two metrics is probably mainly due to the current low-interest-rate environment. Moreover, it should be borne in mind that the valuation level and any assessments derived from it are based on the assumption that the survey-based earnings and dividend forecasts correctly reflect market expectations, which is not necessarily the case. The dividend discount model metrics should therefore not be looked at in isolation, they should be seen as components of a broad indicator approach.