The relationship between the value of the euro and inflation

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October 13th, 2014

The trend in prices has been the focus of attention in the euro area for the last year. The inflation rate recorded in September was one third of the figure recorded a year ago (from 1.1% in September 2013 to 0.3% in 2014). This fall of 0.8 percentage points has been blamed on the convergence of several temporary or exogenous factors to the economy such as the downward trend in oil prices and other agricultural commodities. In spite of the fact that these factors have played an important role in pushing down inflation, specifically by 0.4 p.p. since September 2013, the trend in core inflation (which excludes these components) has also fallen, decreasing by a total of 0.4 p.p. since September last year.

Although part of the weak underlying trend in core inflation is due to excess production capacity and a domestic demand that is still recovering, this weakness has been exacerbated by the euro's appreciation, starting mid-2012 and increasing its value by up to 10% against the dollar. This effect is particularly strong on two components of the harmonised index of consumer prices or HICP, the first being oil prices, whose downward trend in dollars has been amplified by the exchange rate, with the price in euros being even cheaper.

The second component particularly affected by the trend in the euro is the price of non-energy industrial goods (excluding services and foods), which has a significant weight of 27% within the total HICP. The relationship observed between the exchange rate and this component is intense and negative; i.e. when the euro appreciates the price of these goods falls.1 This is due to the fact that a significant percentage of these goods are imported (so their price in euros falls) and those that are locally produced suffer from competitive pressure to adjust their margins and lower their sale price.

It is important to note that, historically, the price of industrial goods has had a somewhat delayed reaction to variations in the exchange rate. Because of this, and given that the exchange rate started to depreciate as from June when the ECB announced more accommodative measures, we should start to see a gradual reversal to these downward  pressures on inflation caused by the euro. This, however, will not be enough to counteract the pressure still being exercised by the aforementioned underlying factors. Therefore, although we expect inflation to change course over the coming months, it will still remain at abnormally low levels.

1. A 10% depreciation in the nominal effective exchange rate is associated with a 0,40 p.p. rise in the CPI for industrial goods.