Euroland and US: Inflation Falling

• The rapid increase in food and energy prices over the past year has boosted headline inflation in both Euroland and the US to levels not seen since the early 1990s. Speculation concerning the outlook for inflation given recent oil price developments has proliferated. In the following discussion we try to as-sess the direct impact on future inflation of three oil price scenarios and the implications for mone-tary policy.
• Our analysis reasonably concludes that Euroland headline inflation peaked at 4.0% in June and July. Also, as baseline effects begin to kick in around October inflation rates will start to decline. In other words, the period in which inflation has been running at double the ECB target (close to but below 2%) is coming to an end. If oil prices fall faster than our main scenario assumes the case for an ECB rate cut seems increasingly likely.
• A significant boost to oil prices is needed to keep US inflation rates soaring as favourable base effects will kick in by end-2008. According to even our high oil price scenario inflation will peak at 6.0% in early-2009, subsequently following a relatively steep downward trend. A significant spike in oil prices will exacerbate ongoing differences between FOMC hawks and doves. Although the trade-off between growth and inflation risks will become increasingly difficult, nevertheless even if oil prices behave as assumed by our high oil price scenario and inflation follows that path, it will probably not be enough to trigger a Fed rate hike, provided inflation expectations remain contained.

Inflation scenarios - dependence on oil price developments

Central banks throughout the world have been caught in a delicate balancing act between slow growth on the one hand and uncomfortably high in-flation rates on the other. In both Euroland and the US (which are net oil-importing countries/regions) skyrocketing oil prices have played a dominant role with high oil prices pushing inflation on oil- and en-ergy-related goods and services which in turn re-duces consumer purchasing power.

Headline inflation in both Euroland and US is fairly dependent on oil price developments as energy products account for approximately 10% of the consumer price index basket. Furthermore, changes in oil prices are reflected in consumer prices almost immediately.

To shed light on how strongly Euroland and US in-flation depends on oil price developments we have created three oil price scenarios and fed them through our inflation models.

The three oil scenarios:

• Main scenario: Oil prices increase slowly from their current level to around USD 125 a barrel by mid-2009 and then pick-up gradually to USD 135 a barrel by end-2009.
• Low oil price: Oil prices decline gradually by approximately 1/3 to USD 80 a barrel in spring 2009. In autumn 2009 oil prices rebound slightly to USD 90 a barrel by end-2009. This scenario could result from positive non-OPEC supply surprises and/or “demand destruction” in Asia.
• High oil price: Oil prices rebound due to, for example, stronger than expected growth in the world economy implying resilient de-mand despite oil and/or supply surprises (either disappointing non-OPEC production or a “hawkish” OPEC stance). Oil prices are assumed to increase gradually to USD 150 a barrel and to subsequently remain un-changed.

We do not attach any probabilities to the three scenarios as our main objective is to analyse how sensitive inflation rates are to oil price develop-ments.

Implications for US inflation

A big boost is needed to keep US inflation soaring

The rapid increase in food and energy prices over the past year is one of the main reasons why US consumer price inflation is currently running at levels not seen since early 1991. Headline inflation reached its highest level in the current cycle at 5.6% y/y in July with energy price inflation contrib-uting 2.8pp to this reading (see chart below).

Importantly, core inflation has continue to behave itself during the recent rise in headline inflation; we expect core inflation to peak around 2.6% by mid-2009. We assume the core inflation path follows our main scenario (see chart above) for all three oil price scenarios. This may seem stretched as sec-ond round effects are more likely to spill over into core inflation the longer headline inflation remains high. Nevertheless, it is a helpful assumption for our purpose of evaluating the direct effect of oil prices on inflation.

With favourable base effects kicking in by late-2008 a significant upward boost to energy prices is needed to keep US inflation at or above current high levels. As illustrated below, even in our high oil price scenario, inflation will peak in early 2009 be-fore subsequently trending downwards relatively rapidly.

In our base scenario, we predict a peak in headline inflation by August this year at 5.7% y/y and a downward trend from February next year with infla-tion reaching 2.5% by June 2009. In our high oil price scenario, inflation will peak at around 6.0% y/y in early-2009 before subsequently trending downwards fairly quickly, reaching 2.3% by end-2009. Finally, in our low oil price scenario, inflation has already peaked with our models predicting headline inflation of 2.5% as early as April next year.

Monetary policy response

Another significant and rapid oil price spike as as-sumed in our high oil price scenario is likely to cause intensified discussions between the FOMC's doves and hawks.

With inflation running above 5.5% until early-2009 the risk of second round effects is clearly higher than in our main scenario. However, with increas-ing labour market slack and subdued wage inflation, high headline inflation will act as a significant tax on household disposable income and restrict private consumption growth further. The trade-off between growth and inflation risks will become increasingly difficult. Nevertheless, even if oil prices behave as assumed by our high oil price scenario and inflation follows that path, it will probably not be enough to trigger a Fed rate hike, provided inflation expecta-tions remain contained.

While the US economy continues to face serious headwinds, an inflation path as described in our low oil price scenario would be an important support to real personal income and real consumer spending, moving a recovery of the US economy closer. The Fed is unlikely to hike rates until credit market con-ditions improve, but a faster recovery of the US economy would move Fed rate hikes up the agenda earlier than in our main scenario.

Implications for Euroland inflation

Euroland inflation has peaked

Harmonized consumer prices in Euroland rose by 4.0% in June and July. Subsequently, inflation rates reached levels not seen since May 1992.

However the main message from our analysis is that headline inflation has peaked. In all three sce-narios inflation rates do not exceed the level re-corded in June and July. Therefore, it will take a very dramatic rebound in oil prices for inflation to exceed 4%. Furthermore as time goes by this seems increasingly unlikely as base effects (high level for oil prices the year before) will begin to kick in around October.

Core inflation set to rise

The sharp increase in headline inflation experi-enced since October 2007 may be explained by the rapid increase in oil and food prices. So far core in-flation has been contained.

However, core inflation is expected to increase fairly sharply during the autumn and well into 2009. The main reason is that past increases in goods prices which feed into service prices with a lag (see also our recent research on Euroland infla-tion and the inflation dynamics: Research - Euro-land: Core inflation contained, but not for long). The effect on headline inflation is, however, more than offset by an assumed declining contribution from food and energy prices as base effects begin to ma-terialise (around October). This is the case in all scenarios (and of course not least in the high price scenario).

Compared to the main scenario inflation rates re-main higher for a longer period in the high oil sce-nario. Headline inflation stays just below 4% by end-2008 and above 3% until mid-2009. In the second half of 2009 inflation then drops rather sharply to just above 2% by end-2009. Therefore, inflation will remain above the ECB target through-out 2009.

Even in a more extreme scenario (not shown in the chart) where oil prices rebound to USD 150 p/b and remain at this level inflation will not exceed 4.25%; indeed we would expect it to be below 4% end-2009 and to fall gradually next year to around 2% by end-2009.

In our low price scenario inflation stays higher for a markedly shorter time-span, falling to approxi-mately 3% by year-end, and 1.5% by summer 2009 - well below the ECB target. In the second half of 2009 inflation creeps up, reflecting amongst other things, the assumed rebound in oil prices.

We bear in mind that in both alternative scenarios core inflation is assumed to stay unchanged rela-tive to the main scenario. This could turn out to be a rather heroic assumption, as companies gener-ally face higher (lower) production costs due to higher (lower) oil prices. Furthermore, in the “High oil price” scenario, consumer purchasing power is eroded for a longer period, which may lead to higher wage demands.

Implications for ECB rates

We believe the ECB will remain on hold throughout our forecast period as it tries to balance high infla-tion and a weak economy. However should oil prices drop faster than assumed in our main sce-nario it would increase the possibility of a rate cut. Although lower headline inflation in itself stimu-lates consumer demand we think the ECB will ex-ploit any extra room for manoeuvre to support Eu-roland's weak economy which is about to enter re-cession. Given the economic outlook we do not see a case for a rate hike should inflation remain ele-vated as in our high oil price scenario. Therefore, our analysis clearly underscores the point that risks to our ECB call are mainly on the downside.

Danske Bank

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