Global Daily – Eurozone inflation in 2021… it’s complicated

Taking a closer look at the national data – France’s INSEE, the inflation rate of manufactured products (which makes up about a third of core inflation) fell to -0.5% in February, down from +0.8% in January, while services inflation (about half of the total CPI index) declined to 0.7% from 0.8%. Also Spain’s statistics bureau mentioned that core inflation fell by 0.3 percentage points to 0.3% in February. The detailed regional data for Germany’s inflation rate are less straightforward unfortunately. Most states have reported that the inflation rates of the main components of core inflation (e.g. leisure and entertainment, hotels, restaurants, other goods and services, clothing and shoes) on balance did not change a lot in February. Overall, we think core inflation in the Eurozone declined to 1.2% in February, down from 1.4% in January.

Despite the decline in core inflation, the headline rate probably rose further in February due to a jump in energy price inflation, which is partly compensated for by lower food price inflation. This picture also emerged from the national data. Headline inflation probably rose to around 1.1% last month.

A medley of temporary factors – As explained after January’s data, the jump higher reflects a whole range of temporary factors. First of all tax changes. The temporary reduction in the VAT rate in Germany of July 2020 was reversed in January. Also in Germany, a national carbon pricing system for sectors not covered by the EU ETS was introduced.

Second, inflation may been pushed higher by the methodology that statistics agencies are using to estimate prices that could not be collected due to mobility restrictions or closures of shops. For instance, around 23% of all prices in the HICP basket had to be imputed in Germany because of shop closures and other lockdown measures. This will probably not have changed significantly in February, which implies that the data remains distorted by Covid-19. Prices then need to be imputed and past experience suggests this methodology inflates the inflation data.

Third, new (preliminary) weights were used in January to reflect the significant effect that the COVID-19 pandemic had on household consumption patterns. This means that items that have seen sharp falls in demand and hence prices have been given a lower weight in the basket, and hence the impact of any given price fall on inflation is less from January onwards.

Headline inflation will rise to 2% in coming months, while core will be buffeted around – Looking forward, the acceleration of inflation is far from over. Headline inflation will almost certainly rise further in the coming months, to around 2% due to further rises in food and energy price inflation. In terms of the core, we are likely to see further upward pressure from the VAT changes in Germany, especially in the summer due to base effects. Working against these upward pressures, will likely be the fading of statistical upward pressures on inflation once lockdowns end and more accurate price collection can resume. Some of the effect seems to have already faded in February as statistical discrepancies in January may have been exacerbated by discounting. Overall, 2021 looks likely to be a year of relatively elevated inflation.

Headline and core inflation will fall sharply in 2022 – However, it will very likely be a one off. These transitory factors will dissipate come next year, leading to a sharp drop in inflation as the disinflationary pressures from the economic shock come to the fore. It is difficult to explain the current trends in inflation on the back of fundamental drivers, which still look disinflationary. For instance, while core goods inflation was up by 1.4% yoy in December, producer prices ex-energy are flat year-over-year. The latter reflects still subdued global price trends as well as the strength of the euro. More importantly, there remains large amounts of spare capacity in the eurozone economy.  Even assuming a strong economic recovery from the second half of the year, the output gap will likely be in the 3% area even at the end of 2022. For the ECB, it is inflation in 2022-2023 that matters – which looks set to significantly undershoot its goal – rather than this year’s inflation.