Breaking down the fall in inflation in the euro area

The euro area's inflation rate has been slowing up for several months now. The persistence and extent of this downward slide is surprising within a context where domestic demand is actually showing initial signs of recovery. This is particularly worrying in the periphery countries as it hinders both the deleveraging being carried out as well as their ability to continue increasing their competitiveness. A good diagnosis is essential in order to determine whether the ECB should take action and to what extent.




In the first graph we can see that the inflation rate fell by 1.6 p.p. from mid-2012 to January 2014. A drop of this size had not occurred since 2008, when the financial crisis was at its peak. A significant part of this fall is due to factors that can be interpreted as temporary. Energy prices, a factor that is quite volatile but which has traditionally pushed up inflation, have remained relatively stable over the last year and their contribution to the rise in the CPI has therefore diminished considerably. The weakening of the base effect caused by tax hikes in several euro area countries has also helped to bring down the rate of growth in the general price index. What is surprising, however, is the sharp fall in core inflation at constant tax rates as this has historically been more stable and its movements have reflected the underlying trends in economic activity. 40% of the slowdown in inflation is due to the drop in core inflation at constant tax rates.



60% of this contraction in core inflation at constant tax rates can be explained by the fall in the inflation rate for prices of non-energy industrial goods. Together with the price of services, these are a good reflection of the trend in domestic demand. One example of this is that, in periphery countries, where domestic demand has shrunk the most, we can also see a larger reduction in core inflation at constant tax rates. It is important to note, however, that the core inflation rate has historically delayed its reaction to changes in domestic demand. As can be observed in the third graph, the year-on-year change in domestic demand is associated with the core inflation rate seen after a few quarters. We therefore expect core inflation to halt its downward slide over the coming months as the recovery in domestic demand gradually takes hold. However, given that the recovery is not expected to be very vigorous, inflation will probably remain at abnormally low levels for a relatively long period of time. Although the risk of deflation is contained, prolonged low inflation should also make the ECB react.