Euro Area Research: Germany's VAT cut sends euro inflation on a roller coaster

Germany's government keeps opening the spending taps and at the beginning of June unveiled another sizable recovery stimulus package. As part of the package, VAT rates will be temporarily cut from July until December 2020. While the VAT cut is welcome from a growth perspective by boosting consumer spending, it will also have a marked impact on the short-term euro area inflation outlook.

Drawing on the historical precedent of the German VAT hike enacted in January 2007, we expect Germany's VAT cut to lower euro inflation by c.0.2 percentage points on average in 2020 and 0.1pp in 2021. However, we stress that the temporary nature of the current cut might dampen the magnitude of the price effect.

While the VAT cut will depress core inflation rates in the coming months, it will also give an artificial boost in the latter part of 2021. However, we expect the ECB to look through these gyrations in core inflation and focus on the medium-term inflation dynamics to determine its policy stance. Looking into 2021 and beyond, we still see a case for (core) inflation rates to move higher, both due to the mechanical effect from the temporary VAT cut, but also from the unprecedented monetary/fiscal easing and cost push inflation in some industries eventually emerging (see also Euro Area Research - The road to recovery, 14 May).

We remain sceptical that other countries will follow the German example of broad-based VAT cuts, as fiscal fragilities are already looming large. That said, targeted VAT cuts on travel and tourism-related items/services remain a possibility.

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