The precipitous fall in oil prices and virus-related plunge in demand is likely to push euro-zone inflation to a record low of -1% in the summer. While the risk of deflation becoming entrenched seems low, we forecast core inflation to average just 0.5% this year and next – about half its level over the past decade.
- The precipitous fall in oil prices and virus-related plunge in demand is likely to push euro-zone inflation to a record low of -1% in the summer. While the risk of deflation becoming entrenched seems low, we forecast core inflation to average just 0.5% this year and next – about half its level over the past decade.
- Whereas the global financial and the euro-zone debt crises were mainly demand shocks, the virus-related downturn is a shock to both supply and demand. Taken in isolation, a reduction in supply should be inflationary because there are fewer goods and services to meet a given amount of demand.
- However, this is clearly not the only thing going on. While panic-buying may have pushed up prices for some goods, the blanket closure of shops in most of Europe means that people simply cannot buy many things that they otherwise would have done. Meanwhile, a surge in unemployment is likely to cause people to tighten their belts, and companies will have to slash expenditure to try to stay afloat. While government responses will help to limit the damage, the disinflationary effect of this demand shock looks set to dwarf any upward pressure on prices from the supply side.
- If this wasn’t enough, there’s also the small issue of the 60% fall in energy prices since the beginning of the year, driven in part by Saudi Arabia’s decision to increase oil supply at a time when demand was collapsing. With oil prices unlikely to recover until later this year, at the earliest, energy prices alone look set to subtract about 0.8%-pts from headline inflation in the coming months. (See Chart 1.)
- In all, the headline inflation rate in the euro-zone will soon plunge below zero. (See Chart 2.) Previous experience is arguably not much use now given that the current shock will be much deeper but (hopefully) shorter. But for what it’s worth, core inflation fell by about 1%-pt during the global financial and euro-zone crises, to +0.8% and +0.6% respectively. A similar fall now would bring it to zero later this year.
- We think that the risk of deflation becoming entrenched is low because we expect oil prices to rise and activity to recover as and when containment measures are lifted. That said, with supply likely to bounce back more quickly than demand, the resulting negative output gap will keep a lid on inflation over the coming years. Indeed, many people will want to rebuild their savings or pay down newly acquired debts, and many businesses will be paying back loans extended from governments and banks.
- Some have argued that the huge increases in spending and the money supply will add up to higher inflation down the line, but we are sceptical. After all, the experience of QE shows that even huge increases in the money supply have not stoked price pressures – to the chagrin of policymakers.
- All told, while things are much more uncertain than usual, we forecast core inflation to average about 0.5% this year and next. More generally, the further fall in price pressures will only accelerate the mission-creep at the ECB away from its traditional inflation-fighting role to an increasingly quasi-fiscal purpose, which will aggravate the existing divides on the Governing Council.
Chart 1: Oil Prices & Energy Component of CPI
Chart 2: Euro-zone CPI Inflation (%)
Sources: Refinitiv, Capital Economics
Sources: Refinitiv, Capital Economics
David Oxley, Senior Europe Economist, firstname.lastname@example.org