…and why it is not low
There is widespread surprise that Eurozone inflation appears low currently, notwithstanding that real GDP growth is brisk and even accelerating. In this report, we highlight several factors why underlying inflation is not as low as it appears, in our view, and measured inflation is likely to pick up well above expectations in the coming quarters.
Inflation is relatively low at the moment because there are fairly long lags between an economy operating above its potential rate and inflation materialising. In the Eurozone, capacity constraints began to materialise, in our calculations, around the summer of last year and they should reach levels comparable to those seen in 2008 only next year, on our estimates. This means that the recent behaviour of inflation is not likely to prove to be a good predictor of the coming quarters.
Commodities prices are the other big reason inflation has proved more modest than expected in recent years; however, this is no longer the case, at least for fuel prices. We forecast average eurozone inflation at 2% for this year and 2.5% for 2019E, above the ECB’s projections of 1.4% and 1.5% respectively.
We have priced into our models the euro at 1.25 on average against the dollar this year and next, but the risk is biased in favour of a bolder rise, in our view, to 1.40 this year and an eventual reversal to 1.20 next year. Even in this case, inflation is likely to overshoot the ECB’s forecasts.
Forecasting inflation correctly is, of course, enormously important as we come to the end of the quantitative easing programme. However, it is equally important, in our view, to realise that we are most likely underestimating inflation currently, for at least three reasons. It well documented that national statistics are still struggling to correctly measure housing costs: 78.5% of the eurozone population lives in a country with house price inflation above 3%yoy, thus is probably experiencing rising rents too.
The growing use of big data and artificial intelligence is changing the pricing strategy of companies – this in our view already affects a third of the goods of the CPI basket. Faster depreciation of a product is an increasingly widespread sales strategy for companies, which de facto is a form of inflation for consumers. In our view this affects 16% of the CPI basket.
If we are correct on this, then there will be important implications for monetary policy, consumer spending prospects and political changes going forward. #ChangingEurope
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