European Reflation: All that Glitters ain’ t Gold

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Annual inflation in the Eurozone has surged to its highest levels since 2013. Having already hit 1.1% in December 2017, it has now jumped to 1.8% in January 2017, according to Eurostat. Despite the consumer price growth acceleration, the European Central Bank insists that the aggressive monetary stimulus must continue. Draghi’ s attention is focused on the ongoing modest economic growth (0.5% in the last three months of 2016, the fastest rate in a year), slowly declining unemployment (at its lowest rate since 2009), and inflation which does really look likely to meet ECB’ s goals. Why is it not all good news then?

Figure 1: CPI (see glossary) for the Euro Area (2012-2017) has recently experienced a massive spike up (1.8% in January 2017) far more than expected recently. Data from Eurostat |

First of all, a repentine rising inflation is usually bad for consumers, so that it is likely to expect a decline in economic growth in the next quarters, because wages takes more time to adjust to goods and services price changes. The reflation may soften consumer spending and real income growth. Questions arises on how smoothly this inflation trend will keep on rising in the next future. Second of all, we need to understand what those inflation numbers, which are outpacing forecasts and expectations, are telling us. What is looking really good numbers might turn out to be bad news for ECB: the picking up inflation tells something about what happened last year, which is not important for the outlook, and tells something also about oil prices surging up a bit this year, which is bad news for the outlook. Countering those positive news previously mentioned, core inflation remains below 1% (see figure 5), with no sign of any underlying inflation or positive price pressure, which is what the ECB really needs to see if it is going to be able to unwide the unprecedented monetary stimulus.

Energy Prices and CPI

We do not think this uptick in inflation points to a high level of inflation over the long term. A closer look at the CPI (consumer price index) (see definitions and use here) components displays that the increase in energy prices is widely behind this up-trend.

Figure 2: base effects of the oil price volatility ($/b) on the overall rate of inflation. Data from Federal Reserve Economic Data (FRED)

For instance, crude oil prices were in their 20$/b’ s last year and are now in their 50$/b’ s and this looks like the pressure we are seeing in the numbers reported by Eurostat, with this trend set to accelerate to the early months of this year. As a matter of fact, fluctuations in crude oil prices represent the effects that modify how the energy component impacts inflation. In fact, we can see a positive relationship between oil prices and the energy component of inflation (we collected monthly data for the last three years just to clearly show it, but it can be displayed also for the last twenty years in Europe and US as well)

Figure 3: Empirical relationship between crude oil prices (Europe-Brent) and the energy component of CPI. The figure shows a stable relationship between log_crude oil prices and the log_energy component of CPI over the period 2014-2017. Data from Federal Reserve Economic Data (FRED)

For example, when the price of crude oil dropped in mid-2014, the energy component of HICP largely contributed to the downward trend of the overall rate of inflation. Instead, when oil prices started to rise again, this preassure gradually began to fade away and crude oil prices started pushing overall inflation upwards in late 2016 (see charts).

Figure 4: Contribution of the energy prices to the overall HICP in Europe. Data from Eurostat

The importance of the Core Inflation

Without the Core Inflation (see glossary), the ECB won’t move. In the Eurozone the 0.9% in December and January is on trend with its 2016 average. The base effects of the rise in oil prices should continue to push up inflation in the Eurozone in 2017, but these effects’ last or disappearance are going to depend on oil prices level future trend. If the rising inflation trend is to last, Core Inflation will have to pick up steam as well. ECB forecast for GDP growth is 1.7% in 2017, in keeping with 1.7% in 2016, which is not likely to be enough to fill the output gap as far as the ECB is concerned, so that the rise in underlying inflation might not be as large as desired. If this is actually the case, the possible rise in the overall inflation this year will not last over the medium-longer term. Therefore, the ECB is not going to react to inflation datas and expectations, as remarked by Mario Draghi during the last press conference.

Figure 5: Excluding energy, food, alcohol and tobacco, core inflation in the Euro Area remained steady at 0.9% in January of 2017 over the same month in the previous year. Data from Eurostat |

Little high, little low

We shall not only decompose inflation measures into internal components but also across Eurozone regions. Looking at the HICP  index (see glossary) as a measure of Inflation across European countries we can notice that inflation is rising but diverging, making policy decisions more troublesome for the ECB. For instance, while in Ireland consumer prices are almost flat, in Belgium and Germany we are above the Euro Area average, with some cases like Spain in which inflation rate is well above the 2% target.


Figure 6: Map. Overall HICP Inflation rate by countries in Europe (January 2017). Data from Eurostat


Figure 7: Chart. Overall HICP Inflation rate by countries in Europe (January 2017). Data from Eurostat. For larger figures visit Eurostat.

German politicians, whose economy’ s inflation is now 1.9%, have been able to boost pressure on the ECB to abandon the low interest rate policy that is eroding people’ s savings, given that the combination of rising inflation and zero rates represents a negative factor for the value of their money. Germany is heading to the polls later this year and criticism of the ECB is increasing the political tensions, including potentially disruptive elections among other European countries, such as France.

Figure 8: Excess Inflation, %yoy. Data from Bloomberg, retrieved from Riskelia’s Blog

Figure 8 shows a regime change: in 2012 Spain had the highest excess inflation (see glossary) and Germany the lowest but for the last five years their trends have inverted. Italian excess inflation has now turned into the lowest among the major Euro Area economies and it is the only major European economy with positive 10-year real yields (see glossary).

Figure 9: Spread between German Inflation and Italian Inflation, CPI. Data from OECD
Figure 10: In its latest peak, the inflation spread trend exceeds 95% confidence interval, far above forecasted trend based on past observations. Data from OECD

There’ s  a huge inflationary divergence within Europe (as shown in Figure 9). The chart shows Germany inflation minus Italy deflation and one can see it is quite cyclical: we have 3 peaks over the period of 20 years, which represent excessively high German inflation than relatively low Italian. Out of the four possible outcomes of a difference or ratio between two relationships (in which they can follow both the same direction up and down or diverge, that is one up and one down), currently we are experiencing a new massive blow up out of the norm, oddly unique in more than 20 years of historical observations, at least two standard deviations above the mean (see Figure 10). There are real concerns on the first derivative of price change, the slope if you would, of that movement of inflation, and not only in Germany, but Sweden and many other countries as well.

Is there a limit to Germany inflation? One could see if the time series presents a persistence, which can be defined as the tendency of inflation to revert to its mean or long run level after a shock. As we get off the mean, things happen within a system to compress this surge in relative price change and as we get a higher move there are compensating factors that limit the shock. For instance, in econometrics, under the so-called univariate approach, persistence is investigated by looking at the univariate time series representation of inflation, which is usually assumed to follow a stationary autoregressive process of order p (AR(p)). The concept of persistence appears linked to the impulse response function (IRF) of that process.

In order to have a clue of what might happen in the next future, we will try to think about the issue in economic terms. The difference between most southern countries and northern ones in the Eurozone level of inflation is mainly explained by their current account imbalances. For example, Germany experiences a huge current account surplus, mainly due to an undervalued currency, strong manufacturing, relatively low energy prices, weak internal consumer demand and a stock of savings relatively higher than investments (with respect to the GDP), which favor exports (see here and here). Given the imbalances in the Eurozone, southern European economies face a long period of deflation, very costly in terms of lost GDP and high unemployment. The upward trend in inflation rate and current account surplus for Germany might be set to continue if the expansion in oil and gas prices slows as expected, as Germany is a net importer.

Figure 11: German and Italian inflation rates trends. Data from OECD |

ECB’ s Impossible Challenge

The political conflict of interests between European countries is now evident: if the ECB were forced to stop its expansionary monetary policy to support German inflation (but also French or Spanish), Italy’s crisis would almost certainly keep going. The ECB represents the only economic doping factor for Italy’s financial stability with respect to the sustainability of its public debt. If sovereign yields soar in case of financial tightening by the ECB, Italian banks would be likely to suffer a lot (see here and here), spreading a possible banking crisis across Europe and even the country’ s current miserable growth prospects would worsen. As a result, current reflation dynamics are crucial given that a tightening monetary policy creates vulnerabilities within the Eurozone which increase with inflation divergence.


Glossary (from Eurostat):

  • CPI: The consumer price index, abbreviated as CPI, measures the change over time in the prices of consumer goods and services acquired, used or paid for by households.
  • Core Inflation: inflation excluding more volatile components like energy or food prices.
  • HICP: The harmonised index of consumer prices, abbreviated as HICP, is the consumer price index as it is calculated in the European Union (EU), according to a harmonised approach and a single set of definitions.
  • Excess Inflation: the inflation differential between any given country and the Euro Area average.
  • Real yields: nominal yields less annual consumer inflation.

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