- Drop in oil prices is depressing headline inflation and inflation expectations, but is good for growth
- We have revised down our US and eurozone inflation forecasts, but see a gradual uptrend in 2015
- The lower profile for inflation in the near term is more of an issue for the ECB than for the Fed
Sharp fall in oil prices leaves its mark on inflation
Oil prices have been falling significantly in recent weeks, both in terms of the Brent and WTI. This is leaving its mark on inflation. Headline rates of inflation will be lower over the next few months. A one off fall in oil prices will lower annual inflation for a whole year, essentially until it falls out of the series 12-months later (assuming oil prices do not move further subsequently). As such, we have lowered our headline inflation forecasts in the US and the eurozone for 2014 and 2015 (please see below). In addition, the fall in oil prices pushes down inflation expectations derived from bond market pricing, even at longer-term horizons. The chart shows that 5Y5Y inflation expectation in the eurozone has recently been strongly correlated with oil prices. The same is true for the equivalent measure in the US (not shown). However, the impact of oil prices on longer-term inflation is not straightforward. Core inflation (ex food and energy) has been rather stable on a year-on-year basis recently. In addition, lower oil prices tend to give consumers more disposable income, which means stronger demand. That is good news not bad news! Against this background the implications for monetary policy are mixed. We think at the current juncture the fall in oil prices is more of an issue for the ECB than the Fed. This is because inflation is too low in the eurozone and the ECB is worried that inflation expectations become dislodged. This makes ECB easing more likely. As noted on these pages previously, this would likely mean an expansion of the central bank’s asset purchases. The impact on the Fed’s policy is less obvious.
Eurozone inflation to remain low in coming months
The fall in oil prices will lower the profile of eurozone inflation over the next few months. Inflation is now likely to remain below 0.5% yoy until the Spring of next year. Beyond that we expect inflation to move gradually higher, helped by the impact of the lower euro. Against the background of moderate economic recovery, we think a period of ‘bad deflation’ is very unlikely. Core inflation has been stable at just below 1% over recent months. It could creep up in the second half of next year. Both headline and core inflation will likely remain comfortably below 2% though. Headline inflation is likely to average 0.5% this year and 0.8% next year (previously 1%).
US inflation pushed by housing costs – forecasts revised lower due to oil prices
Turning to the US, September data for inflation were out on Wednesday. Headline CPI rose by 0.1% mom in September, following a decline of 0.2% the previous month. This was slightly higher than the consensus forecast which was flat. Energy prices dropped by 0.7% mom, reflecting lower gasoline prices, while food prices increased 0.3% mom. Core prices, which strip out food and energy rose 0.14% mom, picking up from a soft core inflation in August. Rent of shelter moved up (0.28% mom vs 0.20%), reflecting higher owner’s equivalent rent and rent of primary residence. On a year on year basis, both headline and core consumer prices rose by a modest 1.7%. We expect headline inflation year on year to continue trending downward in the coming months, partly as a result of the strengthening of the dollar and lower energy prices. We have adjusted our headline inflation forecast in 2014 to 1.7% from 2% and to 1.6% from 2.2% in 2015 to capture the impact of lower energy prices. The path of inflation and core inflation in 2015 shows that it will pick up gradually in the second half of the year, with both around 2% in the second half of the year. This is in line with the Fed’s objective. Given this, we maintain our forecast that the first Fed rate hike will come in June 2015. This reflects the background of ongoing significant falls in the unemployment rate and dissipating slack, pointing to a pick-up in inflationary pressures further out.