Energy price inflation to drive up headline rates - Capital Economics
Global Economics

Energy price inflation to drive up headline rates

Global Economics Update
Written by Gabriella Dickens

Advanced economy headline inflation rates are set to jump by an average of nearly 2%-pts in the coming months as energy inflation picks up and, in some cases, the effects of last year’s temporary cuts in VAT cuts go into reverse. But with core inflation remaining subdued in most countries, and central banks everywhere more tolerant of higher inflation, policymakers will look through this rise.

  • Advanced economy headline inflation rates are set to jump by an average of nearly 2%-pts in the coming months as energy inflation picks up and, in some cases, the effects of last year’s temporary cuts in VAT cuts go into reverse. But with core inflation remaining subdued in most countries, and central banks everywhere more tolerant of higher inflation, policymakers will look through this rise.
  • Since the start of the pandemic, any upward pressure on inflation from COVID-related supply constraints has been more than offset by the disinflationary impact of subdued demand, the plunge in oil prices in March and April 2020 and, in some cases, temporary VAT cuts. The headline OECD inflation rate fell from 2.2% in December 2019 to below 1% in May 2020 and was still only 1.2% in November. However, there are two reasons why headline inflation rates are likely to rebound this year.
  • First, we expect a sharp rise in energy price inflation in the first half of the year. Even if oil prices hover around $55pb in the coming months, base effects will ensure a jump in energy price inflation on the anniversary of last April’s collapse in oil prices. We expect that energy price inflation will go from knocking around 0.6%-pts off the OECD headline rate in November to contributing around +1.0%-pt in April. (See Chart 1.) That would push inflation up by about 1.5%-pts to above 2.5%. After this purely arithmetic acceleration, the contribution of energy price inflation will drop back only slightly in the second half of 2021, as the Brent oil price continues to rise towards $60pb by year-end.
  • Second, the expiry of temporary cuts in VAT in Germany and the UK will also push up headline rates in those countries. VAT was raised back to its pre-pandemic rates in Germany at the end of last year, which we estimate will add around 0.3%-pts to headline inflation in January. (This will push up aggregate euro-zone inflation by 0.1%-pt.) Meanwhile, the VAT rate in the UK is set to return to 20% in March, which we estimate will add around 0.4%-pts to the headline rate in April this year.
  • Despite the marked rise in the prices of various agricultural commodities during recent months, we doubt that food price inflation will push headline rates even higher this year. There are three reasons for this. First, while the GSCI Agriculturals Index has risen by 30% since January 2020, it has had little relationship with food price inflation in OECD economies over the past decade. (See Chart 2.)
  • Second, agricultural commodity prices were not the major driver of consumer food prices in advanced economies last year, and the same is likely to be true this year. Food price inflation in the OECD jumped from 1.9% in December 2019 to an 11-year high of 4.6% in June, but global agricultural commodity prices fell over this period. Instead, it was downstream COVID-related supply constraints and panic buying that drove up food inflation, both of which should continue to ease in 2021. These factors are likely to overwhelm the recent rise in global agricultural prices.
  • Third, it typically requires much larger moves in global agricultural prices to cause a significant spike in advanced economy inflation. This reflects the fact that, unlike in EMs – where food constitutes a large part of the CPI basket – in OECD economies it accounts for just over 10% of the basket. The spike in OECD food inflation in 2007-08 was caused by a rise in global agricultural prices, but back then the S&P GSCI Agriculturals Index rose by over 70%.
  • All told, we expect these one-off factors to push up OECD headline inflation from 1.2% in November to a peak of 2.8% in May this year. The big picture, though, is that outside the US core price pressures are set to remain subdued. And, in any case, we expect policymakers everywhere to be more tolerant of higher inflation. Therefore, central banks will look through any rise in headline inflation rates.

Chart 1: Brent Oil Price & Energy Contribution to
OECD Headline CPI Inflation

Chart 2: GSCI Agriculturals Index & Food Contribution to OECD Headline CPI Inflation

Sources: Refinitiv, OECD, Capital Economics

Sources: Refinitiv, OECD, Capital Economics


Gabriella Dickens, Global Economist, gabriella.dickens@capitaleconomics.com