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Has inflation peaked?

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Has inflation peaked?

In November, US and eurozone inflation rose to its highest level in decades and there is widespread concern that central banks will have to tighten monetary policy more quickly than previously anticipated. However, after increases earlier in the year, energy prices have fallen in recent weeks. In this Macro Flash Note, GianLuigi Mandruzzato looks at the outlook for energy prices and the implications for headline inflation. The conclusion is that headline inflation should decline starting in December, partially relieving the pressure on central banks.

GianLuigi Mandruzzato
GianLuigi Mandruzzato

November inflation was very strong. Measured using the Consumer Price Index (CPI) or Harmonised Index of Consumer Prices (HICP), headline inflation rose to 6.8% year-on-year (yoy) in the US and 4.9% yoy in the eurozone, values not seen in the US since the early 1980s and which have never been recorded in the eurozone since its inception in 1999. Excluding food and energy prices, core inflation rose to 4.9% yoy in the US and to 2.6% yoy in the eurozone. Many commentators believe that unexpectedly high inflation will lead central banks to tighten monetary policy faster than previously expected.

However, monetary policy affects inflation with long and variable lags and a policy tightening in the coming months would not have much effect before the end of 2022. It is therefore important to have a view on how inflation will evolve in the coming months: if it were expected to fall significantly, there would be little need for a strong central bank reaction.

The energy component of the November CPI was 33.3% higher than a year before in the US and 27.4% higher in the eurozone. Although energy accounts for only 6% of household consumption in the US and 9% in the eurozone, the increase in energy prices is directly responsible for 30% of total inflation in the US and almost 55% in the eurozone.1 The development of energy prices will therefore be key in determining whether current high inflation rates are temporary and how quickly they will return to more normal values.

The evolution of the energy CPI can be estimated by exploiting the correlation with oil and natural gas prices.2 Statistical analysis suggests that oil prices have been responsible for most of the variation in CPI energy since 2006. Natural gas helps explain energy prices only in the eurozone, but its impact there is 80% less than that of Brent.

The forecasting power of the models can be assessed by stopping the estimation in December 2020 and comparing the model projections to the end of November 2021 with the official data. Charts 1a and 1b show the annual changes of CPI energy in the US and the eurozone, the in-sample projections of the models and the 67% confidence intervals. Given the actual evolution of oil and natural gas prices, both models would have correctly projected a strong increase in the energy CPI, although they underestimate the November data by about 15%.3

Chart 1a. US energy CPI in-sample projection

Chart 1A.jpg

Chart 1b. Eurozone energy HICP in-sample projection

Chart 1B.jpg
Source: Refinitiv and EFGAM calculations.

To forecast future CPI energy changes, some assumptions must be made about oil and natural gas prices. An agnostic scenario sees prices remaining at current levels through the end of 2022. When evaluating the conditional forecast of CPI energy, it must be acknowledged that the agnostic scenario is more aggressive than market expectations: futures contracts anticipate a 5% drop in oil prices by the end of 2022 and a drop of more than 30% in European natural gas prices.

Chart 2a. US energy CPI conditional forecast

Chart 2A.jpg

Chart 2b. Eurozone energy HICP conditional forecast

Chart 2B.jpg
Source: Refinitiv and EFGAM calculations.

Charts 2a and 2b show the conditional forecasts of energy price changes through December 2022, together with 67% confidence intervals in the US and the eurozone. Under a scenario of stable energy commodity prices, energy CPI inflation declines rapidly in the US and turns negative in the third quarter of 2022. In the eurozone, the decline is initially gradual and accelerates only towards the end of 2022, although it always remains positive in the period considered. In both markets, the contribution of energy prices to total inflation falls by more than 2 percentage points over the period considered (see Chart 3).

Chart 3. Energy CPI contributions to headline inflation (yoy)

Chart 3.jpg
Source: Refinitiv and EFGAM calculations.


In the absence of commodity price increases, the energy component of inflation is forecast to fall sharply in 2022, contributing to lower overall inflation. In the US, this will not be enough to bring inflation close to the 2% objective of the Federal Reserve, but it could lead the central bank to normalise monetary policy more gradually than some observers expect.

In the eurozone, the decline in the rate of change of energy prices will, together with VAT normalisation in Germany, likely return inflation close to, if not moderately below, 2% by the end of 2022. This provides a rationale for the ECB to look through the current high inflation and maintain an accommodative policy.

1 The overall contribution of energy prices to headline inflation is higher because when energy prices rise they impact the production costs for most sectors and eventually result in higher prices for a broad range of goods and services.
2 For the US and the eurozone, two error correction models are estimated using monthly data from January 2006 to November 2021. CPI energy is estimated as a function of oil prices - WTI for the U.S. and Brent for the eurozone - and a trend. While the price of natural gas TTF is statistically significant in the model for the eurozone, Nymex natural gas prices are not significant in the US model. Commodity prices are expressed in US dollars in the US model and in euros in the eurozone model. The adjusted R2 is 0.65 for the US and 0.77 for the eurozone model.
3 It is also notable that the US model has a much wider confidence interval than the eurozone model. The volatility of energy prices in the US is twice as large as in the eurozone because the smaller tax component in US consumer prices of energy goods makes them more sensitive to changes in underlying energy commodity prices in international markets.