In Japan, possibly more than anywhere else, it is important to distinguish the dynamics between headline and core inflation. Headline inflation – at 0.5% in January – is bound to rise further, led by higher energy prices. By contrast, core inflation is still deeply in deflationary territory, and this trend is amplifying. Excluding perishable food products and energy, the consumer price index (CPI) declined by 1.2% year-on-year in January, the biggest decline since March 2011. The services sector even has reported the strongest deflation since 1970 (-2,8%), mainly due to the sharp drop in mobile phone charges, down more than 50% since March 2021. Medical services were also down (-0.8% y/y), as was durable household goods (-3,0% y/y), and leisure goods (-1.1% y/y)
The question of the persistence of high inflation matters because it will determine the extent of monetary tightening necessary to bring inflation under control. Key factors are growth of unit labour costs, the price elasticity of demand and its mirror image, the pricing power of companies. The latter two are conditioned, at least in part, by the cyclical environment: when growth is very strong, price elasticity of demand will be lower and pricing power higher than normal. A regression analysis between the PMI output prices index and the PMI input prices index (explanatory variable) shows that recently in the US and the euro area, pricing power has increased quite significantly
As shown on our Pulse, the sharp increase in inflation has continued in January, with the harmonised index of consumer prices (HICP) up 6.1% y/y in January. Although the details of last month’s inflation have not yet been revealed, energy prices should remain, unsurprisingly, the main driver of higher consumer prices. The energy element of the HICP recorded a jump of 40.2% y/y in December 2021, whilst the sector’s production prices nearly doubled (+95.9% y/y) between December 2020 and December 2021.
Although Germany is not the eurozone country experiencing the highest inflation rate, the trend is nevertheless uncomfortable. Consumer prices posted another hefty rise in January (+5.1% y/y, harmonised index), although this was less than in December 2021 (+5.7%). The end of positive base effects – caused by the end of the VAT rate cut in place in the second half of 2020 – did not therefore result in a marked fall in inflation.
Usually close, French and German inflations, measured on a comparable basis by Eurostat’s harmonized index of consumer prices (HICP), have diverged sharply since the beginning of 2021, with inflation on the other side of the Rhine largely exceeding that in France. In November 2021, the gap reached +2.6 percentage points compared with an average of +0.2 pp since 1991. This difference is, for a part, due to a VAT effect: the decrease in the German rates in the second half of 2020 initially pulled down German inflation but the return to their previous level reverted that trend in 2021. In January 2022, with the end of this VAT effect, German inflation fell back quite significantly (to 5.1% y/y according to Eurostat’s flash estimate, from 5.7% in December) but is still very high
In his press conference last week, Fed chairman Jerome Powell was very clear. Based on the FOMC’s two objectives – inflation and maximum employment – the data warrant to start hiking interest rates in March and, probably, to move swiftly thereafter. In doing so, it will be “led by the incoming data and the evolving outlook”. This data-dependency reflects a concern of tightening too much and makes monetary policy harder to predict. The faster the Fed tightens, the higher the likelihood of having it take a pause to see how the economy reacts.
In Ghana, the warning signs are multiplying. Although economic growth has been fairly resilient, public finances have deteriorated sharply at a time of surging inflation. This is unsettling investors and threatening economic prospects. The central bank has already reacted by raising its key policy rate. But the authorities must reassure that they are capable of reducing the fiscal deficit. For the moment, they have failed to do so. Yet severe financial constraints and a dangerously high debt burden could force them to make adjustments.
The Fed gets serious. Faced with an unprecedented increase in inflation (6.9% y/y in November, probably scarcely less in December) the Federal Reserve will tighten monetary policy more than previously expected.
It was a rare coincidence that last week, four major central banks – the Federal Reserve, the ECB, the Bank of England and the Bank of Japan – held their monetary policy meeting. Considering that they all target 2% inflation, their decisions shed light on the role of differences in terms of approach as well as in the economic environment and outlook. However, they share a preparedness to react when circumstances require. Given the mounting concern about the Omicron variant, more than ever, monetary policy is data-dependent.
After last year’s sudden, deep and a-typical recession, caused by the Covid-19 pandemic, this year has also been a-typical in several respects. Supply bottlenecks and supply disruption have been dominant themes throughout the year, acting as a headwind to growth, both directly but also indirectly, by causing a pick-up in inflation to levels not seen in decades. Under the assumption that the pandemic is gradually becoming less of an issue thanks to the vaccination levels, 2022 should see a normalisation in terms of growth, inflation and monetary policy.
The resurgence of the Covid-19 pandemic and the emergence of the new Omicron variant make the ECB’s task even harder. Although growth should hold at a high level, it is expected to ease, and this trend could worsen, at least in the short term. Meanwhile inflation continues to soar, while becoming more broadbased, and the risk in the coming months is on the upside. Faced with greater uncertainty, the ECB is arguing in favour of patience and constancy while saying it is ready to act in any direction. According to our scenario, which is somewhat optimistic in terms of growth and calls for persistent inflation, the ECB would end its Pandemic Emergency Purchase Programme (PEPP) in March 2022 and begin raising its key deposit rate in mid-2023.
The rising trend in prices in the USA is far from over and has become a real focus of attention. In November 2021, inflation was 6.8% year-on-year (yy), its highest level since June 1982. Although soaring energy prices (up 33% yy) contributed to the increase in the cost of living, as in previous months, these were no longer the sole cause. Even stripping out energy and food, inflation was still 4.9% in November, another record. Having risen by 3.9% yy, rents, which represent the main item of expenditure for households (33% of the index), are beginning to have a significant effect. Far from being anecdotal, their increase has accelerated month after month in the wake of the surge in real estate prices
The ECB’s meeting on 16 December is highly anticipated, primarily for the central bank’s new growth and inflation forecasts. When it comes to growth, the ECB’s September forecast was for annual average growth of 5% in 2021, 4.6% in 2022 and 2.1% in 2023. It could leave its 2021 forecast unchanged, with the positive figures for Q3 offset by a less positive view of Q4, due to the effect of supply constraints, inflationary pressures and a resurgence of the pandemic. Growth in 2022 will be weakened by the same factors. The scale of the forecast downward revision will indicate the level of the ECB’s concerns. It will also be interesting to see whether any growth ‘lost’ in 2022 will be shifted, in part at least, into a higher forecast for 2023.
In his testimony to a commission of the US Senate, Jerome Powell has acknowledged that inflation is less transitory than considered hitherto, adding that, as a consequence, a faster tapering seems warranted. Despite this hawkish tone, the reaction of US Treasuries was muted. This may, amongst other things, reflect concern about how the pandemic might evolve. The new Omicron variant undeniably represents an uncertainty shock for households and companies. It comes on top of a negative supply shock that is already a clear headwind to demand. It clearly makes the task of central banks more complicated than ever when deciding how much of a monetary headwind they can create.
The ECB insists on the need for patience before considering a policy tightening, despite current elevated levels of inflation. It believes that inflation will decline next year and that a wage-price spiral is unlikely to develop. Moreover, inflation expectations remain well anchored. Demand in the euro area is suffering from the headwind created by the jump in energy prices. Reacting to this type of inflation by tightening monetary policy would create the risk of reducing demand even more. To avoid such an outcome, it makes sense for the central bank to wait for more information to arrive, thereby adopting a risk management approach of monetary policy
In the euro area, business surveys report record-high staff shortages. They represent a headwind to growth and raise the possibility of faster wage growth and a pick-up in inflation. Thus far, growth of negotiated wages has been subdued but, given its historical relationship with labour market bottlenecks, an acceleration seems likely. Despite the difficulties of companies in filling vacancies, labour market slack has remained above pre-pandemic levels. This situation should improve in the coming months but whether this eases labour market tensions depends on companies’ hiring intentions. Based on recent surveys, these should remain elevated.
The “transitory” surge in inflation is proving to be long lasting. In October, US inflation rose to 6.2% year-on-year, the highest level in 31 years. As in previous months, the main explanation is a ballooning energy bill (which accounts for 30% of this figure), but the acceleration in prices is spreading throughout the US economy. It can be seen in the cost of shelter, which is already up 3.5% year-on-year, and is surely bound to accelerate.
Emerging economies have faced mounting inflation pressures since the beginning of 2021. Headline inflation has continued to accelerate over the summer (except in Asia), primarily reflecting the rise in food and energy prices and weaker currencies against the USD. However, core inflation has also accelerated across the board. As a result, a growing number of central banks in Latin America and Central Europe have started to raise their policy rates. In Asia, inflation has remained low (North Asia) or has levelled off (India), allowing central banks to stay accommodative. So far, central banks engaged in a tightening cycle have increased their policy rate cautiously; even the more reactive ones (in countries such as Brazil and Russia) have remained behind the curve (i.e
Although the significant increase in inflation in most advanced economies is expected to be transitory, it is necessary to focus on the potential consequences of inflation staying temporarily high for longer. Companies that hitherto have been reluctant to raise prices might do so after all, higher inflation could weigh on spending but also cause wage demands to grow, inflation expectations could drift higher, the market sensitivity to growth and inflation surprises would increase and there could be fears about a change in the reaction function of the central bank. In the coming months, investors and central banks will scrutinise data in parallel, but the former will react more quickly should inflation stay high.
In the past few months, activity was hampered by the state of emergency in large parts of the country, which affected in particular the services sector. In addition, the manufacturing sector was confronted with supply disruptions, specifically in the car industry. Finally, the substantial base effects related to the pandemic make it difficult to interpret the year-on-year data.
Since year-end 2020, Eurozone inflation has risen almost vertically. A year ago, year-on-year inflation was still slightly negative, but by September 2021, it had risen to 3.4% (according to Eurostat’s preliminary estimate), the highest level since September 2008. The surge was strongest in Germany, followed by Spain, and to a lesser extent, Italy and France. In Germany, inflation bears the marks of the temporary VAT cut in H2 2020. In Spain, the upturn in energy prices was accentuated by a higher VAT rate on electricity than in most of the other European countries. The updating of weights in the price index also played an important role at the beginning of the year
After the disappointing economic growth reported in H1 2021, Spain should record a robust rebound in activity in H2, assuming the health situation does not deteriorate. The inflow of tourists has picked up (but remains historically low) and employment has recovered. Yet inflationary risks are intensifying. With the surge in energy prices, the government was forced to take drastic measures to reduce the energy bill for households, which will weigh on public finances. Faced with a persistently uncertain environment, the government is bound to maintain an expansionist policy when it unveils its 2022 budget this fall, even though the health situation is more favourable for the moment thanks to the high level of vaccinations
When the pick-up in inflation during a growth upswing is driven by the demand side, inflation is considered to be good. However, inflation can also be bad. In that case, higher prices do not follow from e.g. higher wages due to a tight labour market. Bad inflation rather reflects supply-side shocks. This is, to some degree, the situation that is unfolding in the Eurozone and other economies due to the recent huge increase of oil and gas prices. Bad inflation weighs on households’ real disposable income and hence spending. The impact is expected to be larger for households at the lower end of the income distribution, considering that a bigger portion of their expenditures goes to fuel and in particular heating, and that they also have a lower savings rate.
The new macroeconomic projections of the ECB staff provide sobering reading for savers hoping that, one day, the policy rate will be raised. It is clear that at the current juncture, certain conditions of the recently updated forward guidance on interest rates states are not met. Based on the latest ECB projections, it seems this would still be the case in 2023, even under the hypothesis of a mild scenario. The slow increase of underlying inflation would probably be considered as unsatisfactory. Savers can only hope that the interaction between growth and inflation will evolve or that the ECB projections turn out to be too cautious.
The outcome of the ECB’s strategy review shows that the governing council has carefully listened to what its audience had to say. Its inflation objective is now truly symmetric, which addresses the perception that its previous objective was asymmetric. Three other changes reflect points that were strongly emphasized during the outreach events organised by the Eurosystem. The cost of owner-occupied housing will be taken into account when assessing the inflation environment. The communication will become geared towards a broader public and a decision has been taken to commit to an ambitious climate-related action plan. Now it’s back to the hard work of trying to push inflation up to 2%.
