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ECB Inflation Performance: A Review • The eurozone inflation broke above the 2.0% threshold in December. More importantly, average eurozone inflation since January 1999 rose from 1.98% in November to 2.01% in December. • Other indicators show that inflation remains subdued and below headline HICP, the measure the ECB has chosen to target. This implies the ECB has chosen the most demanding target. • The latest inflation figure has not altered ECB policy, but the language was toughened. Jean-Claude Trichet revisited the wording of the ECB achievement and that of the policy outlook. 128 124 120 116 112 108 104 100 Base 98=100 Chart 1: HICP vs. Ceiling Ceiling 2%/year Actual HICP (SA by BNP Paribas) 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Eurostat, Reuters EcoWin Pro, BNP Paribas Chart 2: HICP Inflation The 2.2% flash estimate for eurozone inflation in December was described in the media as the first time inflation has exceeded the ECB’s target for more than two years. The reality and the potential consequences for ECB policy are more subtle. What is the ECB’s true target? As Jean-Claude Trichet usually puts it, the ECB’s inflation goal is ‘below 2%, but close to 2%, over the medium term’. This time horizon should not be ignored. The cumulative average inflation rate since January 1999 had been above the 2% ‘ceiling’ for a long time by the end of the tightening cycle in July 2008 but the ECB had nonetheless refrained from putting in place a restrictive monetary policy. Mr Trichet recently insisted that, since the start of monetary union, average inflation had been below 2%. He added that he felt "moved" by the EU Parliament applause when he said that average inflation was 1.97%. With the December print, the average has gone to 2.01%...too bad! Will that trigger quick policy action? This is unlikely. When the ECB governing council decided in June 2008 to hike in July, it had at its fingertips the May inflation estimate. This stood at 3.7% y/y, compared with a 4% refi rate. This pushed the average inflation rate from January 1999 as high as 2.22%. That rate hike is often viewed in retrospect as a policy mistake, but not within the ECB. What do other inflation indicators say? The ECB focuses on the headline HICP rather than the ex-food and energy index; the Fed, for example, favours the core PCE deflator. Over the short run, 4.0 Headline HICP (% y/y) 3.0 2.0 1.0 0.0 -1.0 2.0 1.0 0.0 -1.0 -2.0 Core HICP (% y/y) 99 00 01 02 03 04 05 06 07 08 09 10 11 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Eurostat, Reuters EcoWin Pro Headline - Core (y/y) Lagged 1 year Core Inflation y/y Change ignoring highly volatile factors can make sense. However, over the medium term, all elements need to be included in the index that the central bank targets (especially vital elements such as food and energy). Experience also shows that headline inflation tends to lead core inflation (Chart 2). Nevertheless, core inflation remains less volatile. Using one measure rather than the other does make a difference. In December, average inflation since January 1999 was 2.01% while average core inflation was 1.55%. This gap highlights that the main sources of inflation have been food and energy, items over which ECB interest rate policy has less influence. As noted above, the Fed prefers to look at the PCE deflator, a broader measure of inflation. However, the Fed favours the less volatile ex-food and energy definition of the deflator. Although the ECB has not gone down this route, looking at the eurozone PCE deflator would also make a lot of sense. By definition, this index covers all goods and services consumed by Dominique Barbet 20 January 2011 Market Mover 22 www.GlobalMarkets.bnpparibas.com
households. Furthermore, the statistical construction of the deflator captures more effectively changes in consumption patterns. As Chart 3 shows, this measure gives a result very close to that of headline HICP. The average inflation rate until Q3 2010 is marginally below the HICP measure, but the gap is only 4bp. We could also look at the total GDP deflator. By construction, this index is not designed to measure inflation for consumption but for the eurozone domestic economy, since imported inflation is eliminated. This measure shows lower inflation than headline HICP and is less volatile. From the start of monetary union to Q3 2010, average inflation on this measure was 1.68% (0.32pp below the official target). New words to back unchanged ECB policy In the latest press conference, Trichet presented a different gauge of long-term inflation, now referring to the average annual inflation rate over the last 12 years. This measure allows him to still highlight a 1.97% figure (when the inflation from January 1999 to December 2010 is 2.01%). The good thing about this wording is that the reference period and thus the achievement will last for a few months (possibly almost a year), although inflation is likely to remain at or above 2.2% in the next two months of published data. This issue is primarily a question of wording, since other indicators provide comfort on inflation’s past performance as well as the present underlying trend. We expect core inflation for the eurozone stayed at 1.1% in December. The GDP deflator has been subdued: all the quarterly changes (SAAR) since Q1 2009 have been below 1.7%; the latest y/y print is 1.1%; and average inflation over the last three years stands at 1.3%. The ECB currently has no economic reasons to be concerned over the inflation outlook. Even money 130 125 120 115 110 105 100 Chart 3: Price Indices (Q1 1999=100) HICP Headline HICP Core PCE Deflator GDP Deflator 99 00 01 02 03 04 05 06 07 08 09 10 Source: Eurostat, Reuters EcoWin Pro Chart 4: Main Inflation Indices (quarterly, % y/y) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 HICP Core GDP Deflator HICP Headline -0.5 PCE Deflator -1.0 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 04 05 06 07 08 09 10 Source: Eurostat, Reuters EcoWin Pro supply and credit growth, through rising, are not alarming. Trichet merely had a positioning problem since he has lost one argument he had been using heavily – the below 2% average inflation rate since the start of monetary union. The wording change solves this issue for the time being. This device can also be seen as a way for the ECB to avoid current inflation figures exerting too much pressure on the policy setting. Dominique Barbet 20 January 2011 Market Mover 23 www.GlobalMarkets.bnpparibas.com
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