Euro area inflation rates to remain negative until early 2021

September 29, 2020 10:10
Photo: Reuters

Euro area inflation rates fell to -0.2% yoy in August, representing the first time that they have entered negative territory since 2016. Weak energy and industrial goods prices are mainly responsible for the declining rates, which we expect to remain below zero until early 2021. Also, core inflation declined to +0.4% yoy, which is the lowest level on record.

Inflation rates are again negative in the euro area. The trade-weighted exchange rate is 3.5% higher and the oil price in euro is 30% lower than a year ago. As a result, import prices have declined by 1.4%. Also, ex-energy producer prices are negative, indicating that there is little supply side pressure on prices. This is remarkable given that Covid-19 has disrupted many supply chains and could have increased some bottlenecks in the production of goods or increased its costs as social-distancing measures inevitably complicate production processes. Going forward, this will likely remain unchanged as industry expectations on selling prices are negative as well.

Core inflation fell to its lowest level since the start of the European Monetary Union. At 0.4% yoy, this level is the same as the inflation rate that Eurostat uses in calculating constant tax rates. This shows that the temporary reduction in the German VAT is not a major reason for the decline in the overall inflation rate. Service price inflation, in general, declined to 0.7% - again the lowest since 1997. Obviously, the global pandemic has hit some sectors, such as the travel industry, especially hard. The moderation of price pressures, however, seems to be broad-based as inflation rates have declined in almost all sub-categories.

Have we entered a new period where deflationary pressures are prominent? No doubt, headline inflation rates will remain low, and according to our forecast, even negative until February next year. However, they should rise again as the decline of some prices – in the energy space or other sectors that were hit hard by Covid-19 – will not be repeated. The wage and inflation dynamics in general have remained sticky. So far, this has proved beneficial as consumer price expectations have not collapsed as much as other price expectations in the past few months. Still, they are at a relatively low level. Moreover, we expect the euro exchange rate to appreciate slightly such that external price pressures should remain low. As a result, we forecast headline inflation to recover slowly to 0.8% yoy by end-2021 and to 1.2% in 2022.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin