What German re-unification can teach about the inflation outlook

30 years ago , the German c urrency union, which introduced the Deutsche Mark in East Germany as legal tender, came into effect. There are some noteworthy similarities in terms of the macro-economic environment between the time of German re- unification and the current situation. The Euro area, and m uch of the rest of the world, has seen a collapse in economic activity over the last couple of months. Under normal circumstances the depth of the recession would exert a strong disinflationary impulse. But, as has been painfully obvious from the start of the crisis, the current situation is anything but normal and this also makes the outlook for inflation much more uncertain. What is a particular feature of the current recession is a significant “ supply ” shock and massive fiscal support for household income , coupled with a sharp rise in money growth. A similar combination was observable at the start of the German currency union. While production in East Germany collapsed, the introduction of the Deutsch Mark was boosting nominal income, leading eventually to a significant acceleration in inflation. The rise in inflation then prompted the Bundesbank to lift policy rates aggressively. There are, of course, significant differences between the situation back then and today. Crucially, the adverse supply shock is not in any way comparable the collapse seen in East Germany. Moreover, wage and loan growth were significantly higher 30 years ago than currently observed. Overall, we continue to view the risk of a significant rise in inflation in the euro area over the forecast horizon to be small.