A temporary boost
15 May 2018
Eurozone headline inflation stood at just 1.2% in April. That is some way below the European Central Bank’s (ECB) inflation target of “below, but close to, 2%” (See Chart 6). Moreover, underlying core inflation, which strips out energy, food, and other volatile components, was just 0.7%. Some of this weakness is temporary: the early Easter this year pushed up package holiday prices in March, rather than in April as last year, weighing on core services inflation. A bit of a bounce back in the next reading is likely. But it is clear that the Eurozone is not yet experiencing the sustained adjustment in the path of inflation towards target that the ECB has made a precondition for removing its current monetary policy accommodation.
The surge in oil prices over the past year or so is about to provide a significant but temporary boost to headline inflation. Oil prices denominated in euros have risen around 30% in year-on-year terms. If the oil forward curve is right, that could increase to 50% year-on-year over the next few months. Euro-denominated oil prices tend to have a close relationship with the energy component of Eurozone inflation, which is likely to start rising fairly rapidly over the summer (See Chart 7). Energy inflation accounts for about 10% of the overall inflation basket, and could raise headline inflation by as much as 60 basis points between now and August. But again, if the forward curve is right, that boost will fade and eventually turn into a small drag on headline inflation during 2019. Moreover, although higher oil prices mechanically boost headline inflation, given that the Eurozone is a large net oil importer, they also represent a drag on overall economic activity, which could modestly eat into real consumer spending and overall GDP growth.
More fundamentally, Eurozone core inflation is responding only very gradually to the steady erosion of spare capacity and an ever lower unemployment rate. Eurozone unemployment has come down from a peak above 12% in 2013 to 8.5% now, but with only a very small upward move in measures of wage growth and core inflation over that time. In other words, the Phillips curve relationship between measures of spare capacity and wage and price inflation is fairly flat. Structural flattening of the Phillips curve has been a global phenomenon, driven by a combination of globalisation, the reduced bargaining power of labour, and stubbornly low inflation expectations. Admittedly, at a Eurozone member state level, there are growing labour shortages in certain economies. In Germany, the unemployment rate has reached a 36-year low of 5.3%, firms are complaining of labour shortages, and there have been some high profile wage increases, most recently for workers in the IG Bau construction workers union. Germany has historically had among the flattest Phillips curves of Eurozone member states, although recent wage agreements among the unionised labour force may point to some re-steepening of the Phillips curve relationship. Our own modelling work suggests that, even with a steady decline in the Eurozone-wide unemployment rate over the next few years, if the structural flattening of the Phillips curve is sustained then it will be difficult to generate inflation consistent with the ECB’s target once the short-term boost from higher oil prices fades.