The European inflation conundrum

Ophelie Gilbert, CFA
Written by

12th January 2016

Why does inflation matter? It is generally accepted that a moderate inflation rate does not hurt the prosperity and stability of an economy. However, inflation should be neither too high nor too low: excessive inflation or deflation radically changes the behaviour of the two critical economic agents, consumers and companies, and can lead to recession. Today’s low inflation regime prevails in major developed countries, and the fear of deflation remains in market participants’ minds as the spectre of the next Japan.
Is this pattern a result of a change in regime? Since 2000, the inflation rate in the major developed markets has decreased steadily. The globalisation of the economy, the rapid development of China’s growth, and the emergence of emerging countries as major economic players are supporting this cycle of disinflation through lower import prices and lower labour costs. This downward trend in inflation was refuelled by the financial crisis in 2008-2009, and the resulting global excess capacity and the necessity of deleveraging have pushed growth and inflation significantly lower.

Past performance is not a reliable indicator of future results.
More specifically, the sovereign debt crisis in 2011-12 accentuated the downward trend in inflation for the Eurozone. In the aftermath, the core inflation of the Eurozone, which mostly reflects domestic inflation pressures, has declined as slack in the labour market jumped higher. Since 2013, the ongoing fall in international commodity prices has also caused the headline inflation rate to collapse, since this measure includes what economists call the volatile components: commodities and food. So the inflation rate that is prevailing today is not only about oil, but the result both of internal factors and the diffusion of global factors with many transmission channels. In 2015, core inflation even passed below 1%, which is a strong warning level for any central banker.
Why is a low inflation rate so critical? First, low inflation makes for less efficient central bank policy, as its means higher real interest rates. Second, low inflation becomes more troublesome if it is too low for too long, as it could result in a change in people’s expectations of future inflation. This could trigger a dangerous self-fulfilling loop if expectations are de-anchored, and it is very difficult to reverse disinflationary shocks – as shown in Japan
The European Central Bank (ECB) has – finally – implemented strong action to reflate the economy and stop the persistent decline in inflation, and seems to have had a particular focus on increasing the core rate. The ECB’s objective is for Consumer Price Index (CPI) inflation to be close to but below 2%, which was challenging throughout 2015. You need to remember that central bank credibility is key in order for policy makers to be trusted by the market, and for it to be able to fulfil its mandate. The ECB has therefore first used the full set of ‘conventional’ tools such as interest rate cuts and Long Term Refinancing Operations (LTRO).
In early 2015, the headline rate passed below zero, hurt by the oil price’s second leg collapse. This was the signal that conventional policies were not working enough. The only solution for the ECB was to enter into unconventional measures via large-scale asset purchases to more rapidly expand its balance sheet to try to ensure that inflation will gradually get back to 2%. This is its silver bullet to ward off deflation through two channels. The first is to push down the euro in order to boost core inflation temporarily by increasing imported goods prices, which has a second round effect of boosting growth via more competitive exports. The historical rule of thumb is that a 10% decrease in trade-weighted euro should add 0.5% to core inflation over a period of around two years. The second channel is to lower the real rate as much as possible to foster credit growth and therefore economic growth (which will also help reduce the debt burden of the governments).

Past performance is not a reliable indicator of future results.
Today the ECB seems to be winning the first round. The fear of falling into outright deflation has receded a lot, as shown by the graph below. This has been supported by a very gradual improvement in core inflation, and mostly by ECB quantitative easing which has been viewed as the true engagement to do “whatever it takes” to fight deflation risk. Again, the ECB cannot disappoint and fail.

Past performance is not a reliable indicator of future results
But clearly the market still has doubts about the ECB’s ability to achieve its mandate. The market’s expectations remain at a very low level, as shown by the ECB’s favourite indicator, which is the 5 year inflation rate expected in 5 years. The next graph shows that the level is still well below 2%. The euro inflation market is very cheap and inflation forwards are still low. The market view (extracted from inflation-linked swap rates) is that the annual inflation rate will run below the ECB’s target until 2024.

Past performance is not a reliable indicator of future results.
2016 was supposed to be the year of the rebound for the headline inflation after the huge impact of the oil collapse on the 2015 inflation rate. The theory was that the negative base effects on energy prices would be removed from December onwards, and support a higher inflation rate next year. This remains true to an extent, however, once again, the oil price is playing the fool. The oil market is suffering from excess supply, and these imbalances need to be absorbed. Oil prices will remain the most important driving force for inflation, in both directions. The market is expecting a slight rebound of the oil price over next year, but if oil remains below $40 it will keep the headline inflation far from the ECB’s projection for 2016, and clearly it will again complicate the ECB’s job.

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Past performance is not a reliable indicator of future results.
The ECB’s job is further complicated by the fact that economic growth in the Eurozone is actually on-going, firm and broad-based, and the fall in the oil price is very good news for consumer purchasing power. Nevertheless, consumer price inflation dynamics will be key to the ECB’s reaction function in 2016 in the Euro area.

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