Low inflation: oil and nothing else?

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March 10th, 2016

Although the euro area's growth has been in positive figures for more than two years now, inflation is still at an all-time low. It is often argued that this reflects the weakness of such growth or is used to question the effectiveness of monetary policy. Is it appropriate to use inflation as an indicator of the economy's underlying condition at present?

There can be no doubt that the low inflation rate is partly due to the sharp fall in oil prices and its direct effect on the prices of energy products. Nonetheless some analysts suggest there are additional factors to be taken into account since core inflation, which excludes the energy component, is also far from the ECB's target.

However, such concerns about low inflation can be partly offset by considering the channels via which oil prices affect core inflation. The first channel of impact is the indirect effect the new oil price can have on companies by reducing their production or transport costs. In fact core inflation contains components with a historically high correlation to the price of oil1 which have also reacted sharply to the recent slump. For example, non-durable domestic goods, which do not include energy products of any sort, have followed a very similar trend to the oil price. This is because the price of oil is crucial in the production and transport costs of companies selling non-durable domestic goods, with movements in the price of crude oil consequently being reflected in the final price offered to consumers.

The second channel is the second-round effect produced when agents alter their inflation expectations due to the slump in oil prices and, in turn, these expectations affect the trend in current prices. For example, this would be the case if a change in expectations influenced wage negotiations between companies and their workers.

To discover the extent of such indirect and second-round effects, we have analysed the historical relationship between core inflation and the oil price and have estimated what the level of core inflation would be if the price of oil had not fallen.2 For those with a knowledge of ecometric techniques, what we have done is estimate a model that captures how variations in the price of crude oil have affected core inflation historically and, as from July 2014, we have assumed that the energy component has advanced at the same rate as core inflation to obtain the counter-factual value; i.e. the level of core inflation without any indirect or second-round effects.

As can be seen in the graph, this impact is not small: in the last quarter of 2015, core inflation in the euro area would have been 1.41% instead of the 0.93% observed; a level only slightly below the historical average, as corresponds to an economy growing at a good rate but not yet performing at 100%, and not very far from the ECB's target.

In fact, if the oil price picks up gradually over the coming quarters, as we think it will, both core inflation and especially general inflation will accelerate considerably. Specifically, we expect general inflation to go from its current rate of 0.4% to 2.0% by December this year. Nevertheless, just as today's low inflation rate must not be interpreted as a sign of weakness in growth, its increase will not be due to any fundamental change in economic activity either.

1. ECB «Monthly Bulletin» of December 2014 (Box 3).

2. We use an extension of the model presented by the article «Has ECB QE lifted inflation?» published by Bruegel.