The latest data have revealed a marked divergence in inflation among advanced economies, with the core rate rising in the US but falling in the euro-zone and the UK. This largely relates to temporary factors, particularly the impact of government policies including VAT cuts in Germany and the UK. But there is some evidence that the relative resilience of incomes and confidence in the US has also played a role.
- The latest data have revealed a marked divergence in inflation among advanced economies, with the core rate rising in the US but falling in the euro-zone and the UK. This largely relates to temporary factors, particularly the impact of government policies including VAT cuts in Germany and the UK. But there is some evidence that the relative resilience of incomes and confidence in the US has also played a role.
- On the face of it, the recent divergence has been significant. Euro-zone annual core inflation fell to 0.4% in August and 0.2% in September, while the UK rate fell to 0.8% in August. By contrast, US annual core inflation has risen for two consecutive months to reach 1.7% in August. (See Chart 1.) Statistical differences are not fully to blame: US EU-harmonised inflation has shown a similar rise from a slightly lower level.
- There are several reasons to think that this divergence is temporary and has little bearing on the outlook for inflation or monetary policy. In Europe, core inflation rose in July, partly because of disruption to the timing of clothes sales. This added about 0.5ppts and 0.2ppts respectively to core inflation in the euro-zone and UK, making August’s falls seem steeper and weighing on the euro-zone’s core rate in September too.
- The remainder of the decline can be explained by one-off policy changes. Germany’s standard VAT rate has been reduced from 19% to 16% from 1st July until 31st December this year. In July itself, the impact of this on the euro-zone core rate was offset by the one-off rise in clothing inflation, but the drag from lower VAT showed up in August. Eurostat estimates that at constant tax rates (i.e. ignoring changes to VAT), euro-zone core inflation was 1.1% in August – in line with its average in the first half of the year.
- Admittedly, though, this reflects differing trends between countries. The tax cut was not fully passed on in Germany, so underlying core inflation has risen there. Elsewhere in the euro-zone, core inflation is falling due to demand weakness, particularly in tourism. (See here.)
- The UK Government has also cut VAT for hospitality and tourism, from 20% to 5% between July and next March. What’s more, its “Eat Out to Help Out” scheme led to discounts of up to 50% on dining in August. We estimate that these two policies together knocked 0.6-0.8ppts off core inflation. So, of the 0.8ppt decline in UK core inflation in August, 0.2pp was due to clothing and the remainder to government policy. Both UK and euro-zone core inflation will rise when these policies expire and again on their anniversary.
- As for the US, there are some temporary factors serving to boost core inflation. For a start, falls in some core prices at the start of the coronavirus crisis were considerably larger than those elsewhere. Note, for example, that airfares fell by almost 25% compared to a year earlier in the US in April while the equivalent decline in France was half that size. It is therefore not surprising that the subsequent partial reversal of that slump has been more marked than elsewhere. As we have argued before, this boost will not be sustained.
- There is also evidence that supply constraints are pushing up prices in the US more than elsewhere. Note, for example, that restaurant inflation is rising in the US amid reduced capacity. (See Chart 2.) Inflation in certain supply-constrained goods is rising too. While reduced supply might mean that certain price levels are permanently higher, inflation should stop rising once an appropriate level is found.
- But these capacity constraints might feed through to higher inflation over a number of months. And in the meantime, there is a risk that inflation expectations will start to edge up. It is interesting to note in this regard that such supply constraints do not seem to be exerting the same upward pressure in Europe so far. Chart 2 shows that euro-zone restaurant inflation, for example, has held steady, perhaps reflecting the fact that immediate support to incomes was less generous than in the US.
- Stepping back from recent volatility, we suspect that core inflation will settle at rates slightly lower than their pre-virus norm in the coming months. But if there is a risk of near-term capacity constraints generating a sustained increase in inflation in any developed market, then it is probably the US.
Chart 1: Core Consumer Prices (% y/y)
Chart 2: Restaurant Prices (% y/y)
Jennifer McKeown, Head of Global Economics Service, email@example.com