From Global Inflation to Global Deflation?

Tullia Bucco and Marco Valli, UniCredit Group, Milan.
This article appeared in the December 2008 issue of Current Economics with permission of the author.

Key Concepts: Deflation | Recession | Inflation Forecasting |
Key Economies: Euro Zone | Global Economy |

The Role of Fundamentals

The outlook for global inflation has changed dramatically since the summer. In just six months, most developed countries swung from below-trend GDP growth and a commodity-driven inflation spike to a severe recession coupled with an abrupt inflation slowdown triggered by the bursting of the commodity bubble. Below we provide an update of our study ‘Global Inflation — The Ghost in the Machine?” to take into account the latest inflation developments on a global scale and see what we can expect for the future. While falling commodity prices and base effects will push global inflation significantly lower through next summer, we suspect the next big CPI trend at the global level will be a steady deceleration in core prices bound to last throughout 2009 and 2010 (if not beyond), in response to fast-increasing economic slack.

For those who are not familiar with our original study published in the summer of 2007, we summarize the main findings in a nutshell.

Inflation is a global phenomenon. Using an approach based on principal components, we showed that inflation cycles in 12 OECD countries (Australia, Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, UK, US) are mostly driven by a common factor, which we labeled as “Global Inflation”. We also showed that, in the last twenty years, the main drivers of global inflation are fundamentals: real economic activity (as measured by the unemployment rate), long-term interest rates, and liquidity (M3 money supply/GDP). Unemployment has by far the strongest explanatory power and bites more with a three-quarter lag; long-term rates with a two-year lag, and money with a three-year lag. Commodity prices do have an impact, but this is second order compared to that of fundamentals and tends to fade relatively quickly once the moves in commodity prices reverse.

Commodities in the Driver’s Seat

The last eighteen months have in some sense challenged some of the results we found last year but, more important in our view, have also provided strong support to the general framework on which our analysis was based. In both cases, the unprecedented boom and bust in commodity prices played a key role.

Challenges first: the explanatory power of the fundamental-only model has decreased significantly vs. the model combining both fundamentals and commodities. Of course, this is the direct effect of record volatility in commodity prices, which in 2008 clearly overshadowed any fundamental variable in our model. The role of commodity prices is best seen when looking at the fit of our fundamentals-based model and the model that includes also commodities among the explanatory variables. While the former model fails to catch the recent inflation rollercoaster, the latter does a better job (charts below).

However, we don’t read this as a sign of weakness of our analysis: after all, a model estimated on a twenty-year horizon by definition can’t take into account bubbles, both when they inflate and when they burst. Even after the latest developments, a fundamentals-only model clearly outperforms a commodity-only one, with the unemployment rate that remains, by a large margin, the most powerful driver of global inflation pressures. Coming to what worked well, we think our “global” framework did just fine, as in the past year inflation rates have first surged and then slowed on a global scale — though mostly in direct response to swings in commodity prices. Moreover, the finding that the impact of commodity prices on inflation tends to be temporary has been fully vindicated by the lack of second round effects worldwide in the aftermath of the recent huge commodity shock.

Large swings in commodity prices overshadow fundamentals

Global Inflation Trend based on economic fundamentals Global Inflation Trend based on commodity prices
Source: UniCredit Research  

The Next Big Trend: Prolonged Slowdown in Core Inflation

2008 will be remembered as the year in which erratic commodity price moves dictated the global inflation pattern, but 2009 should be different: we expect it to be the year in which inflation tends to revert toward a more “fundamental” trend. This is where the effectiveness of a global inflation framework kicks in with important implications: in the current environment of highly synchronized growth and monetary policy cycles worldwide, the fundamental variables of our model — unemployment, interest rates and money growth — in the coming quarters will follow a very similar pattern across countries. If fundamentals move in synch, then the trajectory of global inflation becomes easier to assess, of course under the assumption that the swings in commodity prices observed in 2008 will not be replicated.

Synchronized labor market cycles Commodity prices hurt by recession
Labor market cycles Recession and Commodity Prices
Source: National sources, Bloomberg, UniCredit Research  

Due to its strong explanatory power and the relatively short lag with which it affects global inflation (only three quarters), the unemployment rate is the key variable to watch to evaluate the extent and duration of the slowdown in consumer prices at the global level. Interestingly, our analysis in 2007 showed that while the unemployment rate is the key driver of global inflation, wages and earnings are not, suggesting that unemployment matters as a proxy for demand conditions rather than supply constraints. After having troughed at end-2007, our gauge of global unemployment has resumed rising, and the pace of increase is now gathering strong momentum. With all industrialized economies facing a tough recessionary environment, the upward trend in global unemployment has a long way to go. We should therefore expect core inflation rates to slow steadily throughout our two-year forecasting horizon and fall to unprecedented low levels. Headline inflation rates will probably bottom out very close to zero (if not negative) next summer, due to a mix of still falling commodity prices and large favorable base effects on non-core components.

In the current, exceptionally uncertain environment, the risk of deflation is not negligible. In case of a truly nasty recession in industrialized economies, commodities would be hit first, and the labor market would follow suit. Commodity-driven deflation in 2009 followed by outright deflation in 2010 should no longer be considered a tail event.

Deflation in the Euro Area? What Has to Happen to Get There

Eurozone inflation is on a steep downward trajectory and likely to continue well into 2009: after having peaked at 4% in June-July and halved to 2.1% in November, we see consumer prices falling very close to zero in about six-to-nine months, with a rising risk that the yearly inflation rate could turn negative during the summer. However, any such event would be most likely temporary and associated with weaker-than-expected energy and food prices: a generalized and prolonged decline in price levels is not our baseline scenario. Our updated projections envisage CPI up 1.0% in 2009 and 1.8% in 2010, with a trough in the inflation rate at 0.2% in July 2009 and a gradual re-acceleration thereafter. In a nutshell, we have pencilled in a prolonged deceleration in core inflation, on top of which we forecast a (further) large correction in energy and food costs bound to trough in summer 2009, when base effects will display their largest effect in lowering the yearly growth rate of non-core prices. Our technical assumptions include average Brent oil price at USD 52 per barrel in 2009 and USD 70 p/b in 2010 as derived from oil futures, and a moderate EUR-USD appreciation over the forecast horizon.

Output gap leads core inflation ULCs explain current stickiness in core prices
Core inflation and the output gap Stickiness in core prices
Source: Markit, Eurostat, UniCredit Research  

Core Inflation: Prolonged Slowdown is Just About to Start

Core inflation. Core price increases have been hovering just below 2% for some time, showing no sign of slowdown despite the slump of economic activity. This may seem at odds with our view that the output gap is the key determinant of core inflation, but in the short history of the European Economic Monetary Union a certain degree of price stickiness following a long period of sustained GDP expansion is not unusual. A look back at the “dot-com” bust — the only episode comparable to the current economic and financial environment — allows us to detect a few key core price trends that we think will repeat themselves in 2009-2010 and possibly beyond, with the main uncertainty being the difficulty in evaluating the full detrimental impact of the credit crisis on GDP growth, and therefore prices. Here is what we can learn from the 2001-2002 economic downturn.

– It may take a while for core inflation to react to weaker GDP growth.

In the “dot-com” boom and bust cycle, our PMI-based measure of output gap peaked in early 2001 and troughed in summer 2005. Despite the economic downturn gathering momentum throughout 2001, core inflation kept rising unabated until spring 2002. Accordingly, the output gap peaked 13-14 months before core inflation.

– Rising Unit Labor Costs (ULC) are probably to blame for the core’s late response.

Though with a varying lag, our output gap gauge has correctly anticipated all the turning points in core prices over the last ten years, while ULCs have not. However, ULCs don’t disappear from our radar screen, as their informative power is most useful in the vicinity of turning points of major business cycles. Being a typical late-cycle phenomenon, rising ULCs probably play a key role in the delayed response of core inflation to slowing GDP growth after long periods of sustained economic expansion and buoyant labor markets. Core inflation and ULCs peaked simultaneously in spring 2002, the former at 2.6%, the latter at 3.2%.

– Once the core rate turns, a resumption of above-trend GDP is needed to push it back up.

After peaking in 2002, core inflation entered a downward trend that lasted until early-2006, when core prices troughed at 1.2% in response to five years of a widening output gap.

Applying these findings to the current situation, we draw the following conclusions. First and most obvious, the medium-term trend in core inflation is sharply down. With negative GDP growth set to last at least until mid-2009, a tentative recovery in the remaining part of the forecast horizon and no return to above potential before 2011 at the earliest, the economic slack will become huge next year and will continue to increase in 2010. In our projections, this pushes core prices to just above 1% by end-2009, around 0.5% by the end of 2010, and close to zero sometime in mid-2011. Coming to the timing of the downshift, we suspect the trend reversal could happen very soon: in early 2009, wage growth should slow and productivity should benefit from the beginnings of the job shedding process, triggering a deceleration in ULCs. If history is any guide, the start of the downward trend in core prices could be just around the corner. In a context of falling oil and food prices, the first phase of the core slowdown should be helped by a moderation in air tariffs and café/restaurants costs, two items that responded swiftly to the commodity price shock in the first half of 2008 and are now expected to reverse course.

Non-Core Pressures Set to Weaken Further

Energy inflation. Energy is the component that will contribute the most to the disinflation trend expected through next summer, accounting for about two-thirds of the 1.9 percentage point decline in headline inflation between November 2008 and July 2009. Natural gas and electricity prices, which react with a 6-12 month lag to oil price moves, should decline for most of 2009, while base effects will prevail on the positive inclination of the oil future curve and push energy inflation to a low of about -11% in July 2009, followed by a gradual pick up thereafter. On a yearly average basis, we expect energy prices to decline 5.7% next year and rise 5% in 2010.

Food inflation. Momentum in food prices is waning: the yearly growth rate has slowed from a peak of 6.7% in July to a still high 4.7% in October, but the 3-month annualized growth rate is now only 2.5% after having peaked at 10% at the end of 2007. Developments in the soft commodity market — the growth rate of the Commodity Research Bureau (CRB) Foodstuff Index has slowed from 15.5% in the summer to 7.3% in November — and leading indicators suggest the weakening trend in food prices should continue for some time. Food PPI (Producer Price Index), which tends to anticipate food inflation by three to four months, is on a steep declining trend, having slowed to 3.6% after the March peak at 10.1%. This is consistent with food CPI (Consumer Price Index) down to about 3% in the first quarter of 2009, in line with our current projections. An even more impressive message is conveyed by selling price expectations at food producing companies as reported by the European Commission survey. The indicator, which on average displays a 7-month lead vs. food inflation, has declined a whopping 4.5 st. dev from the all-time high hit in September 2007. Taken at face value, this indicator shows that food inflation could fall to 0.0/1 .0% in mid-2009. In our baseline scenario we are less aggressive and expect a trough just below 2% next summer.

Non-core pressures are easing Food inflation will slow further
Core inflation is easing Food inflation easing
Source: Eurostat, UniCredit Research  

Scenario Analysis

In this final paragraph we single out the conditions that could lead the eurozone to experience negative inflation rates, distinguishing between two alternative scenarios. The first one, which we label “benign deflation”, sees the yearly growth rate of consumer prices falling temporarily into negative territory due to weaker-than-anticipated developments in non-core prices. The second one, “core deflation”, consists in a prolonged series of negative readings on the core inflation rate in response to a deeper-than expected recession.

"Benign deflation" What it takes to get "core deflation"
Benign deflation scenario Core deflation scenario
Source: Eurostat, UniCredit Research  

Benign deflation. Given that the trough of our official CPI projections is at only 0.2% — to be hit in July 2009, helped by base effects on energy and food — there is just a thin buffer between our baseline scenario and the “benign deflation” environment. Accordingly, relatively small downside surprises on oil and food prices would suffice to briefly push headline inflation below zero in July 2009. What is probably more interesting at this stage is to see the conditions that warrant a more persistent, though still temporary, inflation fall into negative territory. Due mostly to base effects, the period May-October 2009 needs to be watched carefully: in these six months, the projected inflation rate holds steadily below 1% and averages 0.5/0.6%, significantly less than the cumulative downward revisions (largely oil-driven) to our one-year ahead CPI estimate over the last three months. Therefore, it is not difficult to come up with a scenario in which non-core components drive headline inflation below zero in the central part of 2009. A plausible scenario would be the following:

– food inflation eases to zero by mid-2009 (the lower end of the mechanistic forecast delivered by the model based on selling price expectations) and turns slightly negative in the second half of 2009. This lowers our baseline projection for headline CPI by about 0.4 percentage points.

– Euro-denominated oil prices settle 20/25% below our current technical assumption (i.e. in 2009 they average USD 40 per barrel), subtracting another 0.4/0.5 percentage points from the baseline scenario.

If these conditions materialize, headline inflation would stay negative from May through October 2009, bottoming out at -0.7% in July. In 2009, the yearly average would be only 0.2%.

Core deflation. According to our models, even an abrupt recession should not be able to push core prices into negative territory in 2009. The reason is mostly related to the above-mentioned lag with which real economy dynamics impact on eurozone price developments. But a deep recession next year would certainly increase the possibility that core inflation turns negative in 2010. Based on past elasticity, we estimate that a 2.5% GDP contraction in 2009 could suffice to push year-on-year core CPI slightly below zero on a relatively steady basis starting sometime in the second half of 2010. Obviously, a nasty recession would most likely come in an environment of sharply falling commodity prices, possibly below the levels implied by the “benign deflation” scenario outlined above. Accordingly, in the unwelcome case of a deep recession in the -2.5% neighborhood, the eurozone could end up facing commodity-driven deflation in 2009 and more genuine deflationary pressures in 2010.

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