German VAT hike, and pay round begins – inflationary impact?

Germany hiked its rate of VAT on the 1st January, from 16% to 19%. Given the size of the German economy, the impact of this will be to raise Eurozone inflation by around 0.3-0.4%. Eurozone inflation is running at 1.9% year on year, only just below the ECB’s comfort zone (“below but close to 2%”), so during 2007 we’re likely to see price rises sufficient to provoke further rate hikes. There are two other issues – will German consumption collapse as the result of this price shock, and will wages rise to compensate workers for these higher prices?

Firstly consumption. The big worry is that Germany behaves like Japan did in 1997 – the economy there was only just showing signs of recovery, and the authorities optimistically decided that it could withstand a rise in consumption tax from 3% to 5%. It couldn’t, and whilst there was a consumption boom immediately before the tax hike came into force (consumption growth ran at a +6.6% yoy rate), it collapsed subsequently, and has really yet to recover fully. There’s evidence that Germans have also brought their major purchases forward into November and December, with new car registrations in November up 18% year on year, and retail sales also growing. There’s therefore a real risk that there’s payback in the next few months, and if the ECB hikes into this consumer weakness Germany’s fragile recovery could go the same way as Japan’s did in 1997.

Secondly wages. Germany’s most important trade union, IG Metall, believes that its workers have had a raw deal over the past year. There’s been a significant increase in productivity, yet wage growth has been modest – in other words German company profits have been boosted at the expense of labour. Probably helps explains the great performance of the DAX in 2006 (up over 20%). Union officials are looking for wage rises of 4% for the economy overall, and up to 7% in highly profitable sectors. “The wage increases have to cover the inflation rate, and the VAT of 19% in January has to be taken into account as well. And beyond that workers want to participate in profit growth” said Juergen Peters, IG Metall chairman.

The market’s expectation for Eurozone rates in 2007 is that the ECB will hike once or twice, from 3.5% to 3.75% or 4%. Wage hikes of 7% for significant numbers of German workers would certainly put the upper end of this range at risk.