TalkingEconomics: Europe - could higher inflation curtail central banks' stimuli?

After years of deflationary dynamics, energy inflation is set to lift European and UK inflation significantly over the next few months. However, the energy effects will only be temporary and will have a deflationary impact in the medium term.

3 November 2016

Schroders Economics Team

Investors have been concerned about deflation risk in Europe for years, yet the dynamics of prices are set to become more favourable, potentially shifting the balance of risk from deflation back to inflation.

Eurozone inflation set to return

Over the coming months, the impact from the fall in global oil prices late last year will drop out of the base of the annual comparison of prices. This will cause the year-on-year (y/y) inflation rate in most countries to rise, before peaking in the first quarter (as oil prices bottomed out in February 2016).

All else equal (i.e. if core inflation, food, alcohol and tobacco prices stay stable), we predict this rise in energy inflation will push the headline rate of eurozone inflation to about 1.9% by the end of the first quarter of 2017. However, the impact from energy then fades, suggesting a fall in the headline rate back below 1%.

Fall in sterling to exacerbate the rise in UK inflation

The UK faces similar energy inflation dynamics; however, the rise in inflation is likely to be exacerbated by the fall in sterling following the UK’s decision to leave the EU. The fall in the pound will not only raise energy prices, but food prices and import prices for goods more generally too.

Taking both factors into account, we forecast UK Consumer Price Index (CPI) inflation to rise to above 3% y/y by the middle of 2017, averaging 2.9% over the year as a whole. This is an interim estimate from our quarterly forecast which will be revised in next month’s publication.

Implications for central banks

The European Central Bank (ECB) could find it tricky to add further stimulus as inflation rises in the near term. To make the communication of ongoing stimulus easier, we suggest the extension of quantitative easing (QE) should be announced sooner rather than later. We assume the announcement will take place at the 8 December meeting.

In the UK, while inflationary in the near-term, the fall in sterling and the rise in imported prices will be deflationary further out. The Bank of England (BoE) has always focused on a medium-term inflation target and for the moment, we assume the authorities will maintain the current loose policy environment, and may even loosen further in 2017.

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