Thursday, 16 February 2017

This is What Happens in Inflation’s Year-Long Afterlife

In World Economy News 16/02/2017

American writer William Faulkner once said that “the past is never dead.” But as far as inflation is concerned, it actually spends 12 months haunting everyone before vanishing completely.
When that finally occurs, the effect can be large, obscuring what’s really going on in the economy.
Take price gains in the euro area: They jumped 0.7 percent in January to 1.8 percent, causing much consternation among those who tend to worry that inflation can easily get out of hand. But almost half of that change, according to European Central Bank’s calculations, is due to the fading out of an oil-cost spike 12 months ago.
Without the impact of price history, inflation in the 19-nation euro area would be pretty stable, and pretty low, this year.
This is what economists call a “base effect.” Given that inflation is calculated as a year-on-year rate, a big change from one month to the other can have large effects 12 months later, when that swing drops out of the calculation.
In the case of the euro area, this is what has happened. The price of oil fell more than 40 percent in euro terms between November 2015 and January 2016. As oil-price movements influence price gains as early as the following month, this pushed the euro-area rate to minus 0.2 percent in February 2016.
Conversely, the simple disappearance of that drop from year-on-year inflation accounted for 0.3 percentage point, or about half, of the rate’s 0.7 percentage point jump in January this year, according to an ECB study.
The research estimates that the effect will peak at 0.44 percentage point in February. In other words, even if nothing else changed, inflation would rise another 0.15 percentage point this month, pushing the inflation rate very close to 2 percent.
The effect will diminish in the middle of the year before spiking up again in late summer, each time reflecting the movements of oil prices one year ago.
This means that, all else being equal, the ECB may see the need to do precisely nothing – keeping rates low and letting asset purchases run as planned – until underlying inflation, reflecting wage growth, heads back toward the target of just under 2 percent.
Here’s a primer on ECB QE.
“The recent – and coming – pick up in headline inflation is essentially linked to short term developments,” said Louis Harreau, an economist at Credit Agricole in Paris. “So the ECB should not react to this pick up.”

Source: Bloomberg