The European inflation rollercoaster

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For Europe, the key story for investors to focus on this year is the outlook for inflation. We think this should take precedence over the growth outlook, which has so far dominated the debate, since the inflation outlook can be expected to play a bigger role in terms of future policy action by the ECB.

Headline inflation is back below the ECB’s target of “below, close to” 2% in the eurozone, coming out at 1.6% in December as energy and food price inflation cooled. With crude oil prices now below their levels of the first half of 2018, headline inflation is likely to fall further in the months ahead.

Any evidence of goods and services becoming more expensive at any level?

The search for underlying trends usually involves an assessment of core inflation. This reflects the prices of a basket of consumer goods (and services) minus food and energy. More recently, core inflation has remained at around 1% and is thus even further below target.

The course of core inflation over the medium term should ultimately determine what policy steps the central bank will take next. At the same time, one could ask whether core inflation is the best measure to assess the link between slack in the economy and inflation pressure.

Taking an alternative approach, as favoured by the ECB among others, the core basket can be split into goods whose prices react more readily to changes in economic conditions – known as super-core goods – and goods that are less sensitive to, for instance, a fall in slack in the labour market. A rise in employment tends to lift consumer confidence, encouraging consumers to open their purses and spend more. Growing consumer demand typically allows producers to raise prices, boosting inflation. However, not all types of goods and services react in the same way to this mechanism.

What about super-core inflation?

A focus on super-core goods can help the ECB gauge more accurately whether improving economic conditions are indeed passing through into higher prices, in other words, what the effect of economic recovery is on inflation[1]. Typically, by the way, super-core services prices are more sensitive to domestic economic trends, while international competition has a greater impact on goods.

Excluding particularly volatile prices and giving greater weight in a super-core inflation index to services have been found to curb the volatility of such an index. As a result, tracking a super-core index with those features can arguably help policymakers identify genuine turns in inflation.

In the eurozone, super-core inflation – and in particular, the services component – has been rising gently since the autumn of 2016. So at least at face value, there is evidence that a stronger economy is driving a recovery in domestically generated and cyclically sensitive inflation.

Exhibit 1: Eurozone inflation in December – a decomposition

(1A) Food and energy

The European inflation rollercoaster

(1B) Super-core inflationThe European inflation rollercoaster

Source: Haver, BNP Paribas Asset Management

In the eurozone, super-core inflation – and in particular, the services component – has been rising gently since the autumn of 2016. So at least at face value, there is evidence that a stronger economy is driving a recovery in domestically generated and cyclically sensitive inflation.

Another way to look at underlying inflation is to study a diffusion index. This shows the distribution of price changes throughout the basket. Here we find evidence of a disinflationary shift: there have been more price changes in the flat to 1% category and fewer in the 1% to 2% category in recent months.

Exhibit 2: Eurozone inflation in December – the distribution of year-on year-changes

The European inflation rollercoaster

Source: Haver, BNP Paribas Asset Management

So inflation is not really rising, but what about wages?

Overall, the trend in super-core inflation has hardly been dramatic. So one still has to assume that it will take a long time and a lot of patience on the part of the ECB before headline inflation is back at the target. Since super-core inflation accounts for only a small part of the entire basket, inflation in this part of the basket would have to rise to above the ECB’s target to drag overall inflation up. In other words, eurozone inflation looks set to be stuck at below 2% for the foreseeable future.

However, on the wages side, inflationary pressures are gradually building as pay is rising more rapidly. Will rising wages translate into rising prices, confirming the ECB’s medium-term inflation expectations and allowing it to start raising interest rates for the first time since 2011? Or will companies be unable to pass through higher wage costs, creating a squeeze on profit margins or pressure to cut jobs? We think this is the key question in Europe in 2019 rather than the discussion around the outlook for growth.

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[1] Also see “The responsiveness of HICP items to changes in economic slack”, p.66-68, ECB Monthly Bulletin, September 2014

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