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Recherche Economique Groupe http://economic - research.bnpparibas.com 1 Eurozone, at the roots of subdued inflation Clemente De Lucia  Eurozone i nflation continues to be a case of concern . While food and energy price developments largely contributed to the decline of inflation over recent months , the more domestically oriented core inflation is easing as well.  As the underlying pace of the recover y is still subdued , the output gap, which detects domestic price pressures, is likely to remain quite large and negative over the forecast horizon .  As the sensitivity of inflation to the out put gap has incr eased, this rings other alarm bell s in the eurozone and probably in Frankfurt.  Next week the ECB will join the club of those institutions which have drastically reduced their growth and inflation projec tions. This might open the door to f urther actions from the central bank . At 0.4% in October , eurozone inflation continues to be a ca u se of concern . While its most volatile component s , that is food and energy prices , have largely contributed to the decline of the HICP index , the weakness of inflation has deeper roots. Core inflation which excludes these components and is thus more suited to detect the underlying momentum of inflation , is on a downward path as well. Central banks pay particularly attention to core inflation , as it is very sensitive to developments in domestic factors . W hile central bank s have no power to counter commodity price shocks , which affects mainly energy and food price components and whose effects are normally temporary , they can efficiently use their tools to counter domestic price pressures. Subdued domestic price pressures Several indicators might be used to detect domestic price pressures. Survey data are certainly among them . The PMI survey collect s data concerning firms’ input costs. Reflecting the fall in commodity prices and the past appreciation of the euro , the PMI input cost index is on downward path; the recent euro depreciation has just eased the slowdown without altering the trend . In addition b oth the European Commission and the PMI survey s collect data on firms ’ output prices; these indices do not detect any price pressure as well . Firms are indeed offering significant discounts to stimulate a sluggish domestic demand. To sum up , pressures at the early stage of the price formation chain are very subdued . Excluding energy, domestic produce r prices continue to fall on yearly comparison (chart 1) .  No price pressure in the eurozone ▬ Selling price expectations European Commission ( standardized ) ▬ PMI Input prices (standardized ) ­ ­ ­ Domestic producer prices (ex - energy, y/y left) Chart 1 Source s : Eurostat, EC, Markit  At which speed the output gap is closing? ( Output gap as % of Potential output ) ▬ OECD ▬ European Commission --- BNPP Chart 2 Source s : OECD, EC, BNPParibas Recherche Economique Groupe Flash Recherche http://economic - research.bnpparibas.com 27 novembre 2014 2 Potential output growth reflects the growth which can be achieved without generating inflationary pressures. Leaving asides all the difficulties which might arise for estimating the potential output, the gap between the actual outp ut and its potential is another and quite often used indicator of domestic price pre ssures. Admittedly the output gap could be less precise than survey data for detecting the current magnitude of price pressures ; the latter indeed is released with a monthly frequency, while the potential output has to be estimated, its frequency is normally yearly or quarterly at best and it is quite often subject to ex - post revisions. Yet, it is extremely useful for detecting how price pressures migh t evolve in the future as output gap forecasts (even for several years ahead) might be computed . How large is the output gap? International organization s currently estimate the output gap at around - 3% of potential output and they expect it to narrow progressively over the coming couple of years . Yet, the se e stimates might prove to be too optimistic. Admittedly , eurozone GDP growth surprised on the upside in the third quarter, rising by 0. 2 % q/q, while the consensus was between 0.1% and 0%. Yet, this spike might prove to be short lived. The surprise came mainly from France (+0.3% q/q after - 0.1% q/q in Q2) where inventories alone added 0.3 pp to growth and government consumption rose by 0.8% on a quarterly basis . Survey data suggest that French underlying momentum is , however, much lower , with activity growth close to zero . C onditions out of France are not dramatically better. GDP is still contracting in Italy while in Germany activity is exp anding at moderate pace. We expect the eurozone GDP growth to ease to around 0.1% q/q over the turn of the year. It could gain some momentum but not before the second half of next year, where a combination of positive factors, such as the past effect s of t he depreciation of the currency, the fall in oil prices, easier financial and monetary conditions and less fiscal tightening will pass on the real economy. On average we expect GDP at 0.8% in 2014 and 2015 and above 1% in 2016 , while international organiza tions , despite they have recently slashed significantly down their projections, forecast GDP growth slightly above 1% next year. Although we share the same view on the eurozone, (sluggish recovery, needs to stimulate demand and to boost potential output to avoid a secular stagnation), the OECD and the European Commission expect GDP growth to be above potential already at the beginni ng of next year, while we are more conservative, and given what survey data suggest , we see the recovery gathering some momentum only later in 2015 . According ly , our output gap projections are less rosy , forecasting it still close to - 3% in 2015 and close to - 2% in 2016, while the European Commission for instance estimates it close to - 2% in 2015 and below - 1.5% in 2016. Output gap and inflation It is worth noticing that c ore inflation as a whole (39 services components plus 33 non - energy industrial goods components accounting respectively for around 40% and 30% of HICP inflation) is not the best indicator to gauge how the output gap affect s inflation , as not all its components are sensitive to the output gap . This is for instance the case for some services components such as insurance, health care and utilities, while several non - energy industrial goods components are more sensitive to global factors than to the output gap. Through a simple regression analysi s, it emerges that around 40 components of core inflation, accounting for 60% of the index, are sensitive to the output gap (see chart 3), while the others are more sensitive to external factors such as exchange rates, import prices etc. Given the forecast output gap path, a large number of components of core inflation are likely to record subdued developments going forwards .  Core inflation and output gap ▬ Core index particularly sensitive to the output gap (left) * “ Output gap (% of potential output) % Chart 3 Source: Eurostat, EC, BNPParibas * This index has been obtained detecting all the components of the “classical” core index (39 services components plus 33 of non - energy industrial goods) which are sensitive to output gap developments .  Inflation s ensitivity to the output gap V alue of the output gap coefficient of an inflation equation over different time periods* Chart 4 Source : BNPParibas * Rolling sample analysis (5 years from 1999 u p to September 2014). We estimate a regression linking the core components more sensitive to the output gap to their pas t values, to the output gap and oil price s . While during the period of major stress in financial markets , following the Lehman brother’s collapse, the relationship showed some volatility, it was relatively stable before and after it. Yet , since the beginning of last year, the sensitivity has staidly increased . Recherche Economique Groupe Flash Recherche http://economic - research.bnpparibas.com 27 novembre 2014 3 More alarmingly , there is evidence that core inflation is becoming more sensitive to output gap developments . As shown by a rolling sample exercise , the sensitivity of core inflation to the output gap has increased, raising the risk that core inflation might surprise again on the downside were growth to continue to disappoint (see chart 4) . On the contrary were the eurozone to recover at faster pace than currently expected, then core inflation might rise at faster pace than what was the case in the past. The d evelopments of those components less sensitive to the output gap are also likely to remain su bdued , as the weak dynamic s of commodity prices should more than offset the depreciation of euro. Taking all these elements together we expect core inflation to slightly decline over the coming quarters and to moderat ely increase towards the end of next year and thereafter. On yearly basis, it should decline from around 0.8% this year to around 0.7/0.6% next year and to 0.7% in 2016. Headline inflation should average 0.5% this year and next year before coming back abov e 1% on average in 2016. New ECB projections At next week Governing Council meeting, the ECB will unveil its new growth and inflation projections over the next couple of years. Back in early September, the ECB forecast GDP growth at 1.6% in 2015 and 1.9% in 2016, while headline inflation was at 1.1% and 1.4% in 2015 and 2016 respectively. Next week the ECB will probably follow the other major international organization s in slashing down its projections. The oil price assumption which was embedded in the September projections is no longer valid. A ccording to future oil contract s available mid - August oil price would have a veraged USD107.4 per barrel in 2014, USD105.3 /br in 2015 and slightly below USD 103/br in 2016. With the price of oil currently below USD80 /br, oil prices are likely to be on average below USD90 /br next year and slightly above it in 2016. The new oil profil e that the ECB might have embedded in its new projections might be therefore at least 15% below the previous one. This shock alone might subtract around 0.3 pp from inflation. Yet, the downward revision might be even stronger, as a larger output gap (and the higher sensitivity of inflation to it) would weigh on inflation dynamics as well . Rising deflationary risks might force the ECB into more radical actions A sharp reduction of growth and inflation projections might open the doors to further action s from the ECB, indicating that the measures adopted so far are not produ cing the desired effects . Admittedly, these measures probably need more time than expected to pass on the real economy . Yet, probably the ECB cannot wait too long. When inflation is running at very low levels the risk of falling in to deflation is higher . I nflation has no longer a buffer against negative shocks. As actual inflation rates are a key ingredient of inflation expectations, de clining or even negative inflation rates might push down further inflation expectations and actual inflation as well 1 , in a circular mechanism. Inflation expectations as measured by the ECB Survey of Professional Forecasters (SPF) at a time horizon of one up to two years ahead, have declined to their lower level ever recorded. Even the longer time inflation expectations which detect more how markets assess the credibility of the central bank rather than inflation expectations at that time horizon , are decli ning (see chart 5) When policy rates are at their zero lower bound and nominal market rates are low, declining inflation expectations are particularly worrying as real interest rates increase, depressing even further activity. Correctly, President Draghi stressed that the eurozone has already faced in the past low levels of inflation or even negative printing of headline inflation due to energy price 1 For more details concerning the link between inflation and inflation expectations see “ Eurozone: how serious is the deflationary threat?” Conjoncture J uly - August 2014, BNPParibas  Eurozone f orecast update Updates 2014 2015 2016 Growth ECB September 0.9 1.6 1.9 European Commission October 0.8 1.1 1.7 April 1.2 1.7 NA OECD November 0.8 1.1 1.7 May 1.2 1.7 NA BNPParibas November 0.8 0.8 1.5 September 0.7 0.9 1.5 Inflation ECB September 0.6 1.1 1.4 European Commission October 0.5 0.8 1.5 April 0.8 1.2 NA OECD November 0.5 0.6 1.0 May 0.7 1.1 NA BNPParibas November 0.5 0.5 1.2 September 0.5 0.9 1.1 Table 1 Sources: ECB, EC, OECD, BNP  Inflation expectations are declining Survey of professional forecasters (%) ▬ 5 y ear ahead ▬ 2 Year Ahead “ 1 Year ahead % Chart 5 Source : ECB Recherche Economique Groupe Flash Recherche http://economic - research.bnpparibas.com 27 novembre 2014 4 developments as this has been the case in mid - 2009 . Indeed h eadline inflation p lunged to - 0.6% y/y in July 2009. Yet, in 2009 underlying inflation as measured by the core index was at comfortable levels (at around 1.3%) and not subject to particularly pronounced downward pressures . T his time conditions are totally different as core inflation is low and subject to downward pressures. Mr Draghi defined d eflation in the eurozone as a “ protracted fall in prices across different commodities, sectors and countries with a self - fulfilling expectation ” . As stre ssed above, inflation expectations are already alarming ly low and declining , and although price components are not all in negative territory, the number of indices which are recording very modest annual growth rate s is increasing. This is what emerged considering the 39 components of services inflation (more related to domestic developments) for 15 out of 18 countries. More than 20% of the 585 series considered record falling prices, more than 50% show an annual grow th rate below 1 and almost 70% have an annual growth rate below 2% . Chart 6 suggest s that the eurozone as a whole is not yet in deflation, but it is moving alarmingly in that direction. For all these reasons, next week ECB’s G overning Council meeting will be under the spotlight. Last week Mr Draghi stressed that the Council is “ committed to recalibrate the size, pace and composition of ( what the ECB) purchases ” in order to deliver its mandate, adding that “it is essential to br ing back inflation to target without delay” and “ as fast as possible ” ( here for more details) . This degree of urgency stressed by Mr Draghi suggest s the ECB might unveil new measures soon. On the same line ECB Vice President Mr. Constancio stressed this week that the ECB has to monitor whether the pace of the b alance s heet evolution, given the measures undertaken so far , is in line with the ECB expectations i.e . bringing it ba ck to the levels prevailing in early 2012 (i.e EUR 3000bn). According to Mr Constancio, the ECB might have a better idea of this evolution during the first quarter of next year. Should the pace of expansion not be in line with the ECB expectations, then the ECB might decide to broaden the range of assets it is buying, including government bonds, which should be purchased in proportions to th e state capital key at the central bank (based on the country contribution to the region GDP). Notice that this is the first time that a member of the Council explicitly speaks about the modalities of buying sovereign d ebt securities, another element sugge sting that discussion on further actions within the ECB Council has moved forward. Clemente De Lucia clemente.delucia@bnpparibas.com  Decomposition of services inflation by components and countries % of total █ Below 2% █ Below 1 %  Below 0% Chart 6 Source :, Eurostat , BNPParibas Annual growth rate of 39 services components for 15 countries. In the chart, therefore there are 585 series. Slovakia, Malta and Estonia were excluded as not all services inflation figures were available . Recherche Economique Groupe Flash Recherche http://economic - research.bnpparibas.com 27 novembre 2014 5 GROUP ECONOMIC RESEARCH ● William DE VIJLDER Chief Economist +33.(0)1.55.77.47.31 william.devijlder @bnpparibas.com OECD COUNTRIES ● Jean - Luc PROUTAT Head +33.(0)1.58.16.73.32 jean - luc.proutat@bnpparibas.com ● Alexandra ESTIOT Deputy Head - Globalization, United States, Canada +33.(0)1.58.16.81.69 alexandra.estiot@bnpparibas.com ● Hélène BAUDCHON France, Belgium, Luxembourg +33.(0)1.58.16.03.63 helene.baudchon@bnpparibas.com ● Frédérique CERISIER Public finances - European institutions +33.(0)1.43.16.95.52 frederique.cerisier@bnpparibas.com ● Clemente DE LUCIA Euro area, Italy - Monetary issues - Economic modelling +33.(0)1.42.98.27.62 clemente.delucia@bnpparibas.com ● Thibault MERCIER Spain, Portugal, Greece, Ireland +33.(0)1.57.43.02.91 thibault.mercier@bnpparibas.com ● Caroline NEWHOUSE Germany, Austria - Supervision of publications +33.(0)1.43.16.95.50 caroline.newhouse@bnpparibas.com ● Catherine STEPHAN United Kingdom, Switzerland, Nordic countries - Labour market +33.(0)1.55.77.71.89 catherine.stephan@bnpparibas.com ● Raymond VAN DER PUTTEN Japan, Australia, Netherlands – Environment - Pensions +33.(0)1.42.98.53.99 raymond.vanderputten@bnpparibas.com ● Tarik RHARRAB Statistics +33.(0)1.43.16.95.56 tarik.rharrab@bnpparibas.com BANKING ECONOMICS ● Laurent QUIGNON Head +33.(0)1.42.98.56.54 laurent.quignon@bnpparibas.com ● Delphine CAVALIER +33.(0)1.43.16.95.41 delphine.cavalier@bnpparibas.com ● Céline CHOULET +33.(0)1.43.16.95.54 celine.choulet@bnpparibas.com ● Laurent NAHMIAS +33.(0)1.42.98.44.24 laurent.nahmias@bnpparibas.com EMERGING ECONOMIES AND COUNTRY RISKS ● François FAURE Head +33.(0)1.42.98.79.82 francois.faure@bnpparibas.com ● Christine PELTIER Deputy Head - Methodology - China, Vietnam +33.(0)1.42.98.56.27 christine.peltier@bnpparibas.com ● Stéphane ALBY Africa, French - speaking countries +33.(0)1.42.98.02.04 stephane.alby@bnpparibas.com ● Sylvain BELLEFONTAINE Latin America - Methodology, Turkey +33.(0)1.42.98.26.77 sylvain.bellefontaine@bnpparibas.com ● Sara CONFALONIERI Africa - English and Portuguese speaking countries +33.(0)1.42.98. 74 . 2 6 sara . confalonieri @bnpparibas.com ● Pascal DEVAUX Middle East - Scoring +33.(0)1.43.16.95.51 pascal.devaux@bnpparibas.com ● Anna DORBEC CIE, Hungary, Poland, Czech Republic, Slovakia +33.(0)1.42.98. 48 . 45 anna .d orbec @bnpparibas.com ● Hélène DROUOT Asia +33.(0)1.42.98.33.00 helene.drouot@bnpparibas.com ● Johanna MELKA Asia - Capital flows +33.(0)1.58.16.05.84 johanna.melka@bnpparibas.com ● Ekaterina MOLODOVA Russia and other CIS countries +33.(0)1.43.16. 95 .44 ekaterina . molodova @bnpparibas.com ● Alexandra WENTZINGER Africa, Brazil +33.(0)1.55.77.80.60 alexandra.wentzinger@bnpparibas.com ● Michel BERNARDINI Public Relation Officer +33.(0)1.42.98.05.71 michel.bernardini@bnpparibas.com Recherche Economique Groupe Flash Recherche http://economic - research.bnpparibas.com 27 novembre 2014 6 OUR PUBLICATIONS CONJONCTURE Structural or in the news flow, two issues analysed in depth The information and opinions contained in this report have been obtained from, or are based on, public sources believed to be reliable, but no representation or warranty, express or implied, is m ade that such information is accurate, complete or up to date and it should not be relied upon as such. 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