The risk of seeing a self-perpetuating deflationary spiral take hold in the eurozone is clearly lower today than it was a year ago, thanks to the cumulative effects of intervention (and communication) by the ECB and an economic recovery that was a little stronger than what was expected at the end of 2014. Even with the new decline in oil prices that began in November 2015, and as the weight of energy products in the basket for calculating the HICP (Harmonised Index of Consumer Prices) for the eurozone is going to be reduced in early 2016 (from 10.6% in 2015), inflation measured by this index will gradually recover after having been in the red during much of 2015. Headline inflation should thus narrow the gap with core inflation (excluding energy and food), which today is just below1% year-on-year.
However, this improvement will do little to eliminate the many other deflationary (or, at least, disinflationary) factors likely to hamper the present economic recovery (via their effect on real rates) and to maintain high vulnerability to a genuine risk of deflation should a negative growth shock occur. Under a scenario of continued Euro area economic recovery at a moderate pace (which is today largely consensual), the most likely outcome is that inflation will remain low for longer, yet possibly with significant divergences across sectors (likely to have a complex effect on growth) and countries (with the possibility that it could be an additional factor of tensions among Member States). This perspective has major implications, first in terms of common monetary policy and second as regards the necessary microeconomic treatment (structural reforms) and vigilance concerning new political risks.
Today’s climate is of enduring low inflation rather than deflation
In early 2015, core inflation set an all-time low of 0.6% in year-on-year terms since the creation of the single currency. The spillover of lower oil prices certainly played a role (core inflation is not immune to oil prices since nearly all goods and services include an energy component in their production cost structure, which, if it falls, is always likely to be passed on in the selling price). But disinflationary pressures did not wait for the price of oil to fall: as a reminder, since the Great Recession of 2009-2010, core inflation has never been above 1.5% per year for any meaningful period of time and headline inflation indexes were already in slightly negative territory in a few peripheral countries (Spain and Portugal, not to mention the dire case of Greece) in early 2014 (graph 3).
Core inflation has since slightly recovered but continues to be short of breath (+0.9% in December 2015, or a 0.7 pp contribution to headline inflation, graph 1), in virtual stagnation since the summer and unable to break decisively above 1%.
However, at least two strong signals suggest that the eurozone has been distancing itself, at least temporarily, from a self-perpetuating deflationary spiral.
Little to no acceleration in inflation in sight, in particular for services
However, despite this improvement, the economic climate in the eurozone is not very conducive to pick-up in inflation.
- First, unlike its very swift impact on the energy component of prices (a lag of at most two months, as shown in Graph 2), lower oil prices will influence the various core inflation components in a far more disparate and even enduring manner and are probably going to leave their negative mark on 2016.
- Moreover, the main economic variables that are usually regarded as determining as far as domestic inflationary pressures are concerned will be unlikely to trigger acceleration any time soon (here we restrict ourselves to their impact on services inflation as goods inflation also has a strong component linked to the exchange rate):
The depreciation of the euro will lead to a slight uptick in goods ex-energy price inflation
As it is very unlikely to be driven by services, core inflation should, on the other hand, receive a fillip from a slightly stronger goods inflation dynamic, excluding energy and food (which is looking up after having been extremely low or even negative in 2014 and during most of 2015). This is mainly due to the exchange rate effect via import prices (whereas the persistence of overcapacity is going to continue to limit domestic inflationary pressures. See graph 8).
While the pass-through from the lower euro to import prices was fairly fast, its effect on the bulk of industrial prices, except for energy, was considerably deferred and amortised but still visible during past fluctuations (See graph 9). Accordingly, assuming a stable exchange rate in 2016 (which is in line with our central scenario), some of the 2014-2015 downward effect of the euro’s effective exchange rate is still to make a positive contribution to inflation, along the lines of 0.2 to 0.3 percentage points this year. Such an outlook is consistent with the orders of magnitude of a model such as the one used (Global Model) by the OECD, which projects a 10% fall in the euro’s effective exchange rate (roughly corresponding to the movement observed between the median 2014 level and that of 2015), translates into a pick-up in inflation along the lines of 0.3 percentage points each year for three years).
Overall, under our baseline growth scenario (GDP growth of approximately 1.5% in 2016, with no additional pick-up in 2017), inflation is set to increase but in a very limited manner. Our forecasts of 0.9% in 2016 and 1.5% in 2017 are now at levels comparable (although still slightly lower) with the GDP growth rates that were recently revised downwards by the ECB (1% in 2016 and 1.6% in 2017).
This scenario has a number of implications in terms of growth and the appropriate policy mix:
Prices are continuing to rise slightly in most major sectors
The GDP deflator shows inflation which is slightly higher than the core HICP index
Unit Labour Costs, the output gap and unemployment are not currently conducive to an acceleration
Negative inflation has not prevented a strong recovery in Spain