Wednesday, October 30, 2013

Low, lower, Eurozone inflation

I have been arguing for several years now that medium term inflation pressures in the Eurozone are very low. Furthermore, as written in spring this year (see: Rising deflation risks in the Eurozone dated April 16), I was looking for inflation to drop to 1% and even below. The latest news on the inflation front confirm this assessment. Today, Spanish HICP fell to a level of only 0.1% yoy in October (vs. estimates of a fall from 0.5% to 0.4%). German inflation dropped from 1.6% to 1.3% in October (vs. expectations of a 1.5% reading). Hence, Eurozone HICP is also likely to fall further. In September headline inflation fell to 1.1% and core inflation to 1.0%, materially below the ECB's "below but close to 2%" target.
Over the past years, inflation in the Eurozone was largely driven by higher commodity prices (amplified by a weaker Euro during the sovereign debt crisis) as well as due to significant fiscal tightening (via higher consumption taxes and higher prices for administered goods and services). The chart below shows the development of various inflation measures. The difference between headline inflation (in blue) and core inflation (in black) is down to the swings in commodity prices. As major central banks (Fed, ECB, BoE) slashed rates to 0% and flooded the market with an unprecedented amount of liquidity to counteract the debt crisis and economic weakness, commodity prices shot higher, leading to upward pressure on headline inflation rates. Now, however, the commodity super cycle has ended (see for example my strategy presentation from May) amid a fundamental shift in the supply-demand balance and weaker growth across a large number of emerging market economies. The shift in the commodities market environment has been amplified by the Fed's tapering talk in spring/summer and by improving growth prospects in Europe and the US as this led to a shift of capital out of commodities back into US and European equities.
Eurozone inflation developments
Source: Eurostat, ResearchAhead
What is more, a large part of core inflation during the Eurozone sovereign debt crisis (i.e. since late 2010/the beginning of 2011) was down to fiscal tightening measures. This can be seen in the difference between core inflation and the core measures ex admin prices (in red) and the core HICP constant taxes ex admin prices (in green). These inflation measures try to deduct the impact of higher consumption taxes and higher prices for administered goods and services from the core inflation measure (as these higher prices were due to the fiscal tightening). As can be seen, this adjusted measure has been running below 1% for quite some time and stands currently at 0.7%, i.e. still significantly below core inflation. As additional fiscal tightening measures become less pronounced, this difference should fall further. Moreover, the level of excess capacity in the Eurozone remains at a record high, monetary and credit dynamics are very subdued and the high level of the Euro decreases prices for imported goods & services. 
So far, the record low in Eurozone core inflation was reached at 0.8% in Jan/Feb 2010. However, at that time, the enacted strong monetary and fiscal easing measures lead the Eurozone and the global economy into a fast recovery following the deep recession after the Lehman bankruptcy. The Eurozone composite PMI stood at 53.7 in February, rising to 57.3 in April. Furthermore, commodity prices were rising sharply, leading to rising inflation pressures. Now, however, the composite PMI stands at 51.5, suggesting that Eurozone growth remains below trend for longer and hence excess capacity is unlikely to shrink while commodity prices have been moving sideways (energy) to lower (agriculture). Hence, the low point in Eurozone inflation should not yet have been reached and core inflation is likely to hit a new record low in the months ahead. The ECB will have to take note of these developments.