Core inflation

Prepared by Derry O’Brien, Clémence Dumoncel and Eduardo Gonçalves

1 Introduction

• Established relationships between inflation and its determinants may not hold up or may not be scalable, given the magnitude of disturbances in product and labour markets.
• Understanding the drivers of inflation during the pandemic is helped by adopting a more granular perspective than usual.
• A disaggregated approach is often used by central banks to complement assessments based on headline inflation.
• Typically, such an approach is used to distil underlying (common) trends in inflation or to improve forecast accuracy.
• [2] The role of supply-side effects in particular is likely to be larger than usual for a number of inflation components.
• [3] Price changes associated with such supply-side effects may, in the first instance, change relative price developments and not necessarily aggregate inflation.
• This article illustrates how a more disaggregated perspective can help to gauge the implications of COVID-19, augmenting the regular inflation analysis.

2 How has HICP inflation adjusted so far?

• The main components of HICP inflation responded heterogeneously to the pandemic shock.
• Headline inflation declined from 1.2% in February to 0.1% in May, before dropping into negative territory in August (Chart 1).
• The initial steep decline in headline inflation was mainly due to a fall in the contribution of energy inflation from 0.0 to -1.2 percentage points between February and May.
• During the same period, however, the contribution of food inflation increased, mainly owing to the unprocessed food component.
• From the middle of the year onwards, headline inflation fell further as HICP inflation excluding energy and food (HICPX) also increasingly contributed to the disinflationary tendencies, mainly owing to a decline in services inflation and, to a lesser extent, a decline in NEIG inflation.

Chart 1

(annual percentage changes; percentage point contributions)
• The response of HICPX inflation during the pandemic was modest relative to the decline in activity.
• [5] In this respect, HICPX evolved broadly in line with a Phillips curve-based forecast conditioned on developments in standard activity and slack indicators.
• [6] Assuming that the recessionary impact of the pandemic became fully pervasive in the second quarter, the response of HICPX was broadly in line with expectations (Chart 2).
• The remainder of this article examines the adjustment in HICPX inflation during the pandemic in terms of its short-term persistence and its main drivers.

Chart 2

HICPX inflation response during the pandemic relative to Phillips curve forecasts (annual percentage changes)

Box 1 Decomposing inflation dynamics during the pandemic: an aggregate perspective

• Prepared by Michael Khl Interpreting price dynamics in terms of structural drivers is a regular exercise in inflation assessment and forecasting.
• [7] The model is able to disentangle drivers of real GDP growth and inflation in a coherent framework and thereby inform the analysis of the price adjustment.
• [8] Based on the historical shock decomposition from the NAWM II, Chart A visualises the drivers of quarterly GDP growth (panel a) and HICP inflation (panel b).
• Shocks related to the former have, however, only minor consequences for inflation dynamics.
• The downward pressure on inflation from demand-side factors is more persistent, which is a reflection of price stickiness.
• Inflation is expected to return to its pre-crisis level in the course of 2021, at which time the model sees both supply-side and demand-side factors vanish.

Chart A

Historical shock decomposition based on NAWM II (panel a: quarterly percentage changes, deviations from steady state of 1.5%; panel b: annual percentage changes, deviations from steady state of 1.9%)

3 What explains the adjustment of HICP inflation so far?

3.1 Overview of factors unique to the pandemic

• A diverse mix of domestic and global pandemic-related factors have influenced recent inflation dynamics (Figure 1).
• These factors are of both direct and indirect relevance for inflation, but have in common that they are unparalleled in scale.
• It also holds for the large-scale responses from both monetary and fiscal authorities to the consequences of the pandemic.

Figure 1

Factors that affected the response of inflation to the pandemic shock
• The pandemic has triggered fiscal and regulatory responses with a direct, albeit temporary, impact on inflation.
• In response to the pandemic, several euro area countries have reduced indirect tax rates on a scale not seen before.
• [12] This compares with an average contribution of 0.2 percentage points since 2004.
• This added to the volatility of annual inflation rates, making it more challenging to gauge underlying price trends.
• One example is rents, for which the annual growth rate declined from 1.4% in February 2020 to 1.2% in October 2020.
• However, it could also reflect the introduction of rent freezes in certain cities in response to the pandemic.
• The lockdowns are unique to the pandemic, especially in terms of the magnitude of the supply effects they have generated.
• The remainder of this article contains an empirical analysis of the impact of the lockdowns.

Box 2 The role of microdata in inflation analysis

• Prepared by Lukas Henkel, Alberto Lentini and Federico Rodari Microdata on prices complement inflation analysis based on official price indices by providing additional information on the behaviour of individual prices.
• While official price indices allow price levels and inflation rates of narrowly defined product groups to be tracked, these do not allow the tracking of individual prices.
• Microdata on prices allow additional aspects of price movements to be analysed, e.g.
• Microdata on prices are available from three different sources: web-scraped information collected from online stores, shop scanner data and household scanner data.
• [15],[16] This box provides an example of the use of web-scraped information.
• This decrease in discounts could be one factor that contributed to the temporary surge in food prices observed in the spring of 2020.

Chart A

Number of distinct products available online by country and annual percentage change in the share of products offered at a discount (panel a: index, January 2020 = 100; panel b: year-on-year percentage changes)

3.2 Lockdown-induced inflation persistence

• While there is some evidence of postponements of price reviews, it is likely that the impact on inflation persistence was at most modest and temporary.
• in the tourism and travel sectors) continued to face difficulties in enticing customers.
• Indeed, reducing prices appears to have generated little or no rebound in demand.
• [17] Price imputations are also likely to have imparted some short-lived increase in inflation persistence.
• The recreation sector was heavily affected by price imputations, owing to the non-availability of package holidays and the cancellation of entertainment events.
• This was especially the case for items that typically exhibit relatively low persistence (Chart 3).
• As a result, the overall persistence of inflation during the pandemic may have appeared higher than it actually was for certain components of core inflation, particularly for the second quarter of 2020.

Chart 3

Inflation persistence and price imputations (x-axis: inflation persistence, sum of autoregressive coefficients; y-axis: imputation share, percentages)

Box 3 Insights from PMI data on pricing by firms during the pandemic[20]

• [21] In the case of short-lived changes in activity, prices may even remain unchanged throughout.
• This box uses monthly PMI data for manufacturing and services to gauge the frequency of price changes during the COVID-19 pandemic.
• In the manufacturing sector, the frequency of changes in output prices declined sharply in 2012 and thereafter remained subdued until 2016.
• In the services sector, the frequency of price changes was on a slight downward trend during 2012-2016 and picked up thereafter.
• Firms generally did not respond with greater urgency than usual in changing output prices.
• This may partly reflect the fact that firms update output prices if this is justified by input price changes.

Chart A

Frequency of price changes for manufacturing and services (percentages)

3.3 Lockdown-induced supply effects

• Different approaches can be used to assess whether adverse supply effects may have played a role in the response of some components of inflation to the pandemic.
• One approach used to shed light on the role of demand and supply effects is based on unconditional out-of-sample forecasting exercises.
• [27] On that basis, there is some evidence of supply effects in the second quarter of 2020, mainly for food and non-durable goods (Chart 4).
• semi-durables), supply effects cannot be ruled out, as high imputation shares could mask underlying upward movements in inflation.
• In the third quarter of 2020, any supply effects that existed tended to ease.

Chart 4

Relative forecasting errors for inflation components (x-axis: quantities, y-axis: prices; forecasting error divided by the average of absolute historical forecasting errors)
• A more clear-cut distinction between demand and supply effects ideally relies on a structural identification.
• Five structural drivers are identified: global demand, domestic demand, domestic supply, oil supply and monetary policy.
• [29] The historical decompositions of the first three quarters of 2020 point to a pervasive and dominant downward impact of both domestic and global demand effects (Chart 5).
• These upward supply effects mainly related to certain non-energy industrial goods and miscellaneous services in the second quarter of 2020.

Chart 5

Historical decompositions based on a structural VAR for inflation components for the first to the third quarters of 2020 (percentage point contributions from structural factors to the quarter-on-quarter growth rate of inflation excluding trend, percentage changes)

4 Conclusions

• Summing up, a disaggregated perspective can help to better comprehend the response of inflation to the multi-dimensional COVID-19 shock.
• A disaggregated approach, which goes beyond just analysing the main components of inflation, is particularly suited to current circumstances where past empirical regularities in the interpretation of recent aggregate and core inflation may not apply.
• By taking a disaggregated approach, the analysis in this article points to a dominant role for downward domestic and global demand effects.

INTERVIEW

Interview with Agence France-Presse (AFP)

Interview with Isabel Schnabel, Member of the Executive Board of the ECB, conducted by Jean-Philippe Lacour

• And at the last Governing Council meeting there was still an exceptionally high level of uncertainty.
• Eurozone unemployment is increasing rapidly, core inflation reached historic lows in August, the pandemic is gathering pace.
• Yet the ECB is a little less gloomy about the economic outlook than three months ago.
• We do not see a V-shaped economic development where we return to the pre-crisis path very quickly.
• Instead, we see a protracted recovery that takes time, and the same is true for the inflation outlook.
• Regarding inflation, we never base our decisions on just one month of data; we focus on how it evolves over the medium term.
• We see that our measures provide tangible support to core inflation, which was, however, partly offset by other factors.
• In our monetary policy strategy review, which has just been resumed, we will also listen carefully to the different stakeholders.
• Regarding Brexit, how concerned are you about a no deal that is likely to weigh on economic activity?

SPEECH

International inflation co-movements

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the Inflation: Drivers and Dynamics 2020 Online Conference, Federal Reserve Bank of Cleveland/European Central Bank, 22 May 2020

• 22 May 2020 In my remarks today, I will discuss some analytical issues in understanding the drivers of international inflation co-movements.
• At the same time, I will caution that correlated inflation paths are not inevitable.
• Some underlying forces may contribute to divergent inflation outcomes in the years to come.

International inflation patterns

• [1] A common component accounts for a large share of the remaining variability of national inflation rates: this finding has been confirmed for advanced economies in a range of studies.
• [2] Chart 1 Range of inflation in advanced and emerging economies over time (annual percentage changes) Source: Haver Analytics.
• Although Chart 1 shows high cross-country correlations in headline inflation, Chart 2 indicates that the dynamics differ significantly between headline inflation and core inflation measures that are constructed by stripping out the volatile energy and food components.
• In fact, as shown in Chart 3, there has been an increase in cross-country correlations for headline inflation since the global financial crisis (left panel), but a decrease for core inflation (right panel).


Chart 3 Distribution of pairwise cross-country correlations of headline and core inflation (x-axis: frequency; y-axis: correlation coefficient) Sources: Haver Analytics and national statistical offices.
In the rest of my speech, I will examine the role of a range of factors in these correlated inflation outcomes, including the distribution of underlying shocks, structural changes in the world economy and the role of monetary policy regimes.

Common shocks

• One possible explanation for the synchronisation of inflation is that shocks have become more synchronised.
• Since central banks typically seek to stabilise medium-term inflation and do not neutralise fully the impact of shocks on inflation outcomes, it is plausible that a preponderance of common shocks can account for strong co-movements in the deviations of national inflation rates from their medium-term target levels.
• Moreover, in a world of low inflation and low interest rates it is plausible that the impact of negative shocks on observed inflation is likely to be more persistent, since the available policy space to quickly offset negative inflation shocks is more constrained.
• Under these conditions, there may be prolonged deviations of inflation outcomes away from the inflation aim, with central banks closing inflation gaps over a longer time horizon.
• Chart 4 The relation between the common factor in global inflation and commodity price developments (annual percentage changes)
• At the most basic level, the impact of global shocks on domestic inflation depends on factors such as exchange rate movements and the domestic monetary policy regime.
• For example, it is sometimes neglected that the path for oil prices in US dollars is not the same as the path for oil prices in euro.
• [7] Chart 5 Oil prices in US dollars and in euro (USD per barrel and EUR per barrel)

Structural change and inflation outcomes

• Two categories of structural change may have contributed to greater co-movement in inflation outcomes.
• First, structural changes that increase international interdependence mean that a shock in one region may also affect economic performance and inflation outcomes in other regions.
• Second, structural changes that affect national economies in similar ways mean that there may be a common pattern in observed inflation even if shocks are mainly domestic in origin.
• In contrast, other types of structural change have the potential to contribute to divergent inflation outcomes across countries.
• Economic and financial globalisation influences inflation outcomes through several mechanisms.
• This mechanism is confirmed by empirical evidence showing that increased GVC participation is associated with more synchronised inflation dynamics.
• [10] The degree of GVC integration also helps to explain the contribution of global economic slack to the domestic inflation environment.
• [11] By one estimate, international input-output linkages account for around half of the global component of producer price inflation.
• [17] In turn, as indicated in the introduction, a low interest rate environment means that negative shocks affect inflation outcomes more persistently.
• [23],[24] Finally, it is important to recognise that some structural trends can contribute to divergent inflation outcomes.
• [26] The structure of the international monetary system may also contribute to divergent inflation outcomes.
• For instance, there is a sharp distinction between the major issuers of international reserve currencies and other countries.
• For the former, exports and imports are typically priced in domestic currency, so short-term exchange rate volatility has a much more limited impact on inflation outcomes in those countries than in countries in which exports and imports are typically priced in foreign currencies, with a dominant global role for US dollar pricing.

Monetary policy regimes