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What if lower oil prices turned out to be reflationary for the eurozone?


The essential

The oil-price slump is above all the result of a supply shock, in contrast with the shock that occurred at the end of 2008. It is having tremendous redistributive effects (from sector to sector and country to country) and has naturally produced winners (net importing countries in particular) and losers (exporting countries). Even so, it is not a zero-sum game. To the extent that importers’ share in world GDP vastly outweighs hat of exporting countries, the impact on global growth will be positive overall. However, the extent of its impact is of concern to the eurozone due to existing deflationary pressures.

Add this to the easing of monetary and financial conditions (bullish equity markets, weaker euro and lower interest rates) and a positive sequence of events for the eurozone becomes quite possible, as has occurred in other advanced economies. Through its impact on aggregate demand (consumption and investment), the oil-price slump is ultimately reflationary, despite the apparent deflation it is producing in the short term. 

However, ongoing deflationary pressures should not be underestimated; ultimately, they have nothing to do with trends in energy prices. The reflationary nature of the drop in oil prices will not be enough to contain deflationary pressures related to a lack of dynamic growth and investment in particular.









Could a supply shock give a temporary boost to economic activity in the advanced countries?

The price of oil is naturally very sensitive to the supply/demand balance. The combined factors of supply and demand account for the falling per-barrel price of oil that began last autumn. 

On the demand side of the equation, the changing demand for energy commodities must be distinguished from developments in world trade (which itself is very closely tied to global GDP). Over the past few years, we have seen a downturn in global demand for oil and an increase in supply (mainly due to shale gas development in North America). Lower demand

for oil does not come from weaker aggregate demand for goods. In this respect, the situation today is very different from that of 2008-2009. At that time, the plunge in the per-barrel price of oil of the same magnitude was due to collapsing world trade. But today we are seeing nothing of the sort: world trade continues to grow at an annual rate of 3.5%. Admittedly, global industrial output has declined recently (with a very noticeable downturn in China) but it is far from going into free fall (see chart 1). Lastly, the Purchasing Managers’ Index (PMI) surveys, aggregated to represent global activity, point to continued global economic growth that is very likely to remain above the symbolic threshold of 3% in 2015.

In fact, the slowing demand for energy commodities is attributable to the gradual maturation of production processes in emerging countries and their increasing efficiency. The same trend was noted in developed countries after the oil shocks of the 1970s. The resulting “demand shock” is driving down the price of oil but it is quite different from the generalised shock that hit the demand for goods and sent energy prices tumbling in its wake (2008-2009). To some extent it can be argued that as regards spillover effects on the global economy, this demand shock looks more like some kind of positive supply shock.

A shock to reshuffle the deck

Of course, there are winners and losers. Lower oil prices are having tremendous redistributive effects (from sector to sector and country to country). Net exporters of commodities, most of them emerging market economies, have been hit by a negative shock (lower export earnings and declining tax receipts). On the other hand, for most developed countries –all of whom are net importers of commodities– falling energy prices is supporting economic activity. Even in the United States, it is estimated that the positive effect (households, businesses in the non-energy sector) continues to dominate notwithstanding the growing importance of shale gas development over the past five years.

Even so, it’s not a zero-sum game. The substantial share of global GDP accounted for by net importers of oil still outweighs that of exporting countries; lower oil prices brought on by oversupply (or shrinking demand linked to the maturation of production processes) are therefore having a stimulating effect on global activity. The transmission channels are well-identified. Lower oil prices are increasing the purchasing power of households. Businesses are seeing their profit margins improve. In a “normal cycle”, the benefits would be expected to flow to household consumption and capital spending. However, the gains are at best temporary. Once per-barrel oil prices stabilise, the stimulating effects will then fade over time (within two years). In the short term (the first year), a positive chain of events is far more likely to materialise if consumption and investment have been dampened ahead of time. Ultimately, everything depends on global macrofinancial conditions and the point in the economic cycle. In this respect, the United States and the eurozone find themselves in very different situations: 

  • In the United States, a high correlation is usually observed between oil prices and consumer confidence, especially when there are big swings in petrol prices1. In addition, there has been a steady recovery in private domestic consumption and job creation since 2009 and these factors give the US cycle a heady perfume of normalisation. Conditions in the labour market continue to improve. It is now expected that excess capacity will vanish between now and 2018. Tighter monetary conditions associated with a stronger dollar starting in mid-2014 are not sufficient on their own to overturn this trend. The impact of the oil counter-shock is, without a doubt, positive.
  • By contrast, the result is more uncertain in the eurozone. The environment is deflationary, excess capacity is high and the lending channel is still seized up. Lower energy prices may prompt households to increase their savings rate (because of uncertainty linked to high unemployment or of expectations of further price declines). As far as businesses are concerned, ballooning profits were never sufficient reason for bringing investment projects to completion. With no adequate outlets (internal or external), any excess profits earned would only inflate the corporate cash flows with no impact on aggregate demand. That said, the positive effects of the generalised easing of monetary and financial conditions (weaker euro, lower interest rates and bullish equity markets) should help contain deflationary pressures and increase the chances of a positive sequence of events, as in the United States and in most net importing advanced countries.

1 The low tax on petrol at the pump (relative to Europe) amplifies price fluctuations as price of crude evolves. Furthermore, the weight of this expenditure item in US household budgets accentuates the impact of petrol price fluctuations on consumer demand for other goods and services.


The oil shock will stimulate global growth


There are winners and losers. But it is not a zero-sum game



Economic prospects have not been revised upwards by any measurable extent so far

Without denying the expansionary nature of the oil counter-shock, most economists (the consensus view) remain cautious about the size of the stimulus: the world outlook for growth was just revised in the past few months. There are a number of reasons for this.

  • Macroeconomic models tend to exaggerate the likely impact of an oil shock2. Based on past events, these models overestimate the sensitivity of economic activity to the price of energy. Energy consumption per unit of economic output has been in continuous decline over the past 40 years in developed countries (it has been halved over this period) and the same process is underway in emerging countries.
  • We have been wrestling with the potentially destabilising effects of lower energy prices on some large commodity-exporting emerging economies (lower tax receipts and export earnings can undermine local growth strategies). In the emerging markets bloc as the whole, the growth outlook for 2015 has been dramatically scaled back in the past few months. 
  • Growth forecasts for China’s economy have also been revised downwards but for reasons that have nothing to do with changes in oil prices. On the other hand, lower oil prices should have a stabilising effect on the economy.

To put it simply, it is not the broadly expansionary impact that is being called into question but rather its size, especially in the economies of the eurozone because of the deflationary environment.

Deflation: price indexes and inflation expectations can be misleading

One of the more prominent arguments about falling oil prices is that they will add to deflationary pressures in the eurozone. It is clear that when energy prices massively decrease – as was the case in 2008-2009 or since autumn 2014 – shortly thereafter headline inflation follows suit and slips into negative territory. This is strictly cause and effect. 

But we should not get the wrong idea about the nature of this particular kind of deflation. Not all price declines are created equal: some can be positive for aggregate demand (this is especially the case for commodities, as we have just seen) while others – further lowering of wages when low wages prevail or a further decline in the price of goods when prices are falling – can trigger a deflationary spiral resulting in a drop in aggregate demand...and in asset prices (equities and real estate).

Furthermore, inflation expectation metrics are rarely accurate predictors of future inflation. Experience has shown that expectations are often “naive” (i.e. unreasonably correlated to actual inflation). In recent years, diminishing inflation expectations (in surveys of households or in market expectations) can be explained mainly by falling oil prices. However, even when there is a long-lasting shock to the per-barrel price of oil, there is no reason to revise inflation expectations downwards.

In short, temporarily negative inflation should not be confused with deflation.

...but even so, deflationary pressures should not be underestimated.

In fact, real deflationary pressures are not directly linked to fluctuating energy prices. Neither the consumer price index nor surveys reflect their intensity properly. The core inflation trend (excluding food and energy) provides a more accurate picture. In recent months, core inflation has settled at an exceptionally low level in the eurozone (0.6% yoy in January 2015).

2 It is estimated that every $10 decline in the price of oil equates to a 0.2 percentage point (pp) increase in the growth of OECD countries. In other words, all things being equal, the growth outlook should have been revised upwards by 1 pp since last autumn.



Temporarily negative inflation should not be confused with deflation




The real deflationary pressures have no direct link to  fluctuating energy prices

A proxy of the severity of deflationary pressures within the Eurozone

Each month, Eurostat calculates the Harmonised consumer price index (HCPI) for each Eurozone country and for the Eurozone as a whole. To do this, Eurostat uses the Classification of individual consumption by purpose (COICOP). This nomenclature helps to classify households’ spending allocated to food, health, education, etc. With 12 components broken down into 94 sub-components, the COICOP makes it possible to analyse consumption prices with some granularity.

Here, we are interested in the core HCPI that excludes 17 sub-components related to food and energy. We then calculated the year-on-year change in each of the indices for the remaining 77 sub-components. Finally, we totalled the weight of the core HCPI’s sub-components with a year-on-year change below 1%. This metric can be seen as a proxy of a diffusion index of deflationary pressures. For example, at the end of 2014, we see that this index amounts to over 60% in Italy, while it is nearly 80% in Spain (see chart 5).

Some highlights can be derived from the chart 5:

  1. During the first economic cycle, it appeared to be fairly clear that the apex of the «peak of deflationary pressures» occurred approximately one year following the Great Recession of 2008-2009. Indeed, in terms of the three-month moving average, Germany’s peak in deflationary pressures was in August 2010 at 62%, France’s at 48% in December 2010, Spain’s at 52% in June 2010 and Italy’s at 36% in April 2010. 
  2. In the more recent period, deflationary pressures have grown significantly and spread across the entire Eurozone after the sovereign debt crisis (in January 2015, core inflation hit an all-time low at +0.6% year-on-year and headline inflation is near its all-time low at -0.6%). However, deflationary pressures continue and countries are not all in the same boat: Germany remains well below its 2010 peak in deflationary pressures at 43%, France is near its peak at 46%, and Spain and Italy are well above their peaks at 78% and 62% respectively.

Julien Moussavi, Strategy and Economic Research Paris


To better understand the dynamic effects of deflationary pressures in the eurozone and their origin, we consider the weight progression of components that have risen less than 1% over a one-year horizon in the core consumer price index (core HICP) (see box).

It comes as no surprise that the swiftest spread of deflationary pressures occurred in the countries on the southern periphery of the eurozone (Spain and Italy). In Spain, it is striking to observe that the economic recovery barely managed to stem the spread of deflationary pressures. Unsurprisingly, the continuing recession in Italy over the course of 2014 caused the spread of such pressures to accelerate. In France, the economic stagnation of the last three years was accompanied by a slow increase in deflationary pressures. Of the four largest economies in the eurozone, only Germany’s economy has been spared.

This assessment is borne out by a careful analysis of certain expenditure items. As expected, price trends in the non-durable industrial goods sector confirm (1) the intensification of deflationary pressures in the eurozone in the past 12 months and (2) that France is worse off than Germany (see chart 6).

Slowing inflation: a problem of aggregate demand

These deflationary pressures have no direct link to fluctuating energy prices. They are mostly tied to the economic cycle and are ultimately rooted in the same causes as high unemployment. We saw them develop in the eurozone after the shock of the Great Recession. As inflation is a latent indicator of economic activity, the “deflationary pressure peak” occurs several months after the end of the recession (See box). The example of Spain demonstrates that several years of robust growth across the eurozone are required to sustainably curb deflationary pressures.

In spite of the 2014 recovery, the level of private domestic demand remains below its 2009 high (see chart 7); in other words, excess capacity persists. It is notsurprising to see that deflationary pressures have increased in the eurozone over the past two years. Many countries have fallen into the trap of high unemployment and low inflation. It is striking to observe that even the German economy, although close to full employment, is experiencing excessively low inflation.


In order to measure the reality of deflationary pressures, a detailed assessment of trends in the prices of industrial goods is helpful.

Industrial goods (excluding energy) are the second largest item in the CPI (nearly 27% of the index). In most countries, the price of durable goods has trended downward (impacted by globalisation and technical progress). This is nothing new and it is not in itself a sign of deflation. However, the price of non-durable industrial goods—which account for a much smaller proportion (averaging 8% of the index in the eurozone)—has not seen a trend until recently.

Eurostat provides statistics on the price of industrial goods (durable and nondurable) excluding energy and at constant tax rates. Their inflation slowed down significantly in the second half of 2014. The decoupling of France and Germany is particularly stark. France’s inflation rate is in negative territory, whereas it is near its average in Germany (see chart 6). This clearly reflects the divergence between the German and French economic cycles, particularly in terms of investment. Investment is 10% below its level at the beginning of 2008 in France, while it is slightly above that mark in Germany (see chart 8). Meanwhile, it is remarkable to see that the inflation rate for non-durable industrial goods in the eurozone fell in 2014 to its lowest level since 2005 (the earliest available data), despite the recovery. In other words, GDP growth is still much too low to curb deflationary pressures, all the more so given that investment remains notably lacking.

Finally, this confirms that the eurozone will need to grow at a much greater rate than its potential (assessed at 1%) for several years if it is to overcome deflationary pressures. Finally, the ECB is not telling us anything else with its latest set of economic forecasts (March 2015). Despite forecasting a sustained recovery (GDP growth of 1.5% in 2015, 1.9% in 2016, then 2.1% in 2017), the rise of inflation will be slow (1.8% expected in 2017).

The virtue of QE is that it loosens all monetary and financial conditions

The weaker euro, falling interest rates (in particular on bank loans to SMEs) and rising equity prices amount to a loosening of monetary and financial conditions whose impact on the economy will become clearer six months from now. The easing of fiscal policies is also a supportive factor of growth. We are already seeing a turning point in the eurozone economy with the restoration of confidence and early indicators of accelerated growth at the beginning of the year. In an environment where monetary and financial conditions are highly accommodative, falling oil prices are more likely to stimulate demand than to encourage savings. To put it simply, far from being inflationary, lower oil prices may ultimately prove to be reflationary due to the stimulative effects on aggregate demand3.

The most dangerous situation for any economy is not one where the prices of some goods and services are falling, but one where falling prices are becoming increasingly commonplace, pulling earnings, aggregate demand and asset prices along in their wake. It is the likelihood of such a scenario that is fading in the short term (2015-2016).

That said, it should not be forgotten that several years of robust growth are needed to permanently curb the deflationary pressures at work. The effects of loosening money and financial conditions and of falling oil prices are essentially temporary. But it is still too soon to tell whether a virtuous and sustainable cycle of reflationary recovery is underway in the eurozone.


3 And hence secondary effects on oil demand (the price of oil may advance slightly, pulling inflation expectations along in its wake).








Over two years of robust growth
are required to curb deflationary pressures




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BOROWSKI Didier , Head of Macroeconomic Research
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