Disinflation in the euro area
Speech by Philip R. Lane, member of the Executive Board of the ECB, Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution
Washington, D.C., 8 February 2024
Today, I wish to report on the progress in disinflation in the euro area.
Chart 1 shows the dynamics of headline and core inflation, extended forward through 2026 on the basis of the December 2023 Eurosystem staff projections. Relative to its pandemic low point in late 2020, inflation started to increase in early 2021, rising above the two percent medium-term target in July 2021. Inflation continued to climb through the rest of 2021 and most of 2022, peaking at 10.6 percent in October 2022. Since late 2022, inflation has declined and stood at 2.8 per cent in January 2024. According to the December 2023 Eurosystem staff projections, inflation is expected to stabilise around the two per cent target from about the middle of 2025 onwards.
Headline inflation, core inflation and Eurosystem staff macroeconomic projections
The main factors in the 2021-2022 inflation surge were the direct and indirect effects of the energy shock, together with a set of pandemic-related factors including supply chain bottlenecks and, during 2022, the Russian invasion of Ukraine and demand-supply mismatches associated with the reopening of the contact-intensive service sectors (Chart 2).
By the time headline inflation peaked at 10.6 per cent in October 2022, energy inflation had reached 41.5 per cent. Since then, energy inflation has not only stabilised but turned negative: in January 2024, it stood at -6.3 per cent. The energy shock also contributed to very high food inflation: at 5.7 per cent in January, food inflation has come down substantially from its peak of 15.5 per cent in March 2023 but remains elevated. Core inflation was 3.3 per cent in January, down from the 5.7 per cent peak also in March 2023. The decline in goods inflation has been the main driver in core disinflation, with goods inflation standing at 2.0 per cent in January, down from 6.8 per cent in February 2023. Inflation in the services sector stands at 4.0 per cent, having eased less so far than the other components; its peak was 5.6 per cent in July 2023.
Inflation developments and December 2023 Eurosystem staff macroeconomic projections
(annual percentage changes, percentage point contributions)
Sources: Eurostat, December 2023 Eurosystem staff projections and ECB calculations.
Note: The latest observations are for January 2024 (flash).
Overall, the strong disinflation over the past year largely reflects the unwinding in energy inflation (which, in turn, partly reflects large base effects), which explains about half of the disinflation (Chart 3). In addition, the ongoing easing of pipeline pressures and the relaxation of supply bottlenecks have supported the disinflation in the other HICP components. Monetary policy tightening has contributed to the disinflation process by dampening demand and anchoring medium-term inflation expectations at our two per cent target.
Headline inflation vis-à-vis January 2023
While the December 2022 projections had foreseen considerable disinflation during the course of 2023, the realised pace of disinflation has exceeded these estimates (Chart1). Energy prices not only stabilised but fell considerably in the course of 2023 (Chart 4), including due to the impact of global monetary tightening on world activity levels and commodity prices.
Oil and gas prices
The downward revisions to 2023-2024 growth reflected unexpectedly-weak global demand for European exports and the under-estimation of the adverse impact of the 2021-2022 decline in real incomes and the terms of trade on consumption and investment dynamics. In addition, the scale of deceleration in credit dynamics was underestimated.
During the disinflation process, forecast errors have been small, and even turned negative in recent times (Chart 5 and Chart 6). This stands in contrast to the inflation surge period, which triggered substantial one-quarter ahead forecast errors in September 2021 ECB staff macroeconomic projections and the following rounds.
One-quarter ahead HICP forecast errors – comparison with other forecasters
Decomposition of recent one-quarter-ahead HICP inflation errors in the Eurosystem/ECB staff projections
Charts 7 and 8 compare the current inflation episode in the euro area to a sample of past episodes. The scale of the inflation shock to headline exceeds previous episodes, which reflects not only the energy shock but also the preceding rebound from the very low inflation during the initial months of the pandemic. The disinflation of headline inflation so far is proceeding in a fairly symmetrical fashion. However, core inflation measures have peaked later and remain at relatively high levels from a historical perspective. This is driven primarily by the dynamics of services inflation, whereas goods inflation has already come down more decisively. Amongst other factors, the adjustment of the services sector to rising energy costs and the impact of the price level shock on subsequent nominal wage dynamics is necessarily a gradual process, especially in view of the staggered nature of the wage setting process in European labour markets. In addition, the pandemic reopening effect was still supporting unusually high pricing power in contact-intensive services sectors through the summer of 2023.
Historical inflation and the recent inflation episode in the euro area – headline and core inflation rates
Sources: BIS, Eurostat, and ECB calculations.
Notes: The shaded areas and the orange and yellow lines represent respectively the interquartile range and the median of national headline and core inflation series relative to their peaks during disinflation episodes before 2022 across a panel of 30 advanced economies and 28 emerging market economies. Month = 0 when the headline inflation rate is at its highest during that particular episode. The dark blue line represents the latest developments in headline and core inflation for the euro area, relative to the October 2022 peak. The latest observations are for January 2024.
Historical inflation and the recent inflation episode in the euro area – goods and services inflation rates
Non-energy industrial goods inflation
Sources: BIS, Eurostat, and ECB calculations.
Notes: The shaded areas and the blue and green lines represent respectively the interquartile range and the median of national NEIG and services inflation series relative to their peaks during disinflation episodes before 2022. Non-energy industrial goods inflation refers to a panel of all euro area countries, while services inflation refers to a panel of 30 advanced economies and 28 emerging market economies. Month = 0 when the headline inflation rate is at its highest during that particular episode. The dark blue line represents the latest developments in non-energy industrial goods and services inflation for the euro area, relative to the October 2022 peak. The latest observations are for January 2024.
In the December 2023 Eurosystem staff macroeconomic projections, HICP inflation is projected to decrease from an average of 5.4 per cent in 2023 to 2.7 per cent in 2024 and 2.1 per cent in 2025, and then to stand at 1.9 per cent in 2026 (Chart 1). In 2024, energy inflation should increase as base effects turn positive and some fiscal support measures are scheduled to be discontinued. This is expected to partly offset further declines in food inflation and HICP inflation excluding energy and food (HICPX), implying that headline inflation will fall only gradually in the course of 2024. From the end of 2024, all the main inflation components are expected to continue to ease, supporting headline HICP inflation in reaching the ECB’s target in the second half of 2025.
Inflation could decline more quickly in the near term if energy prices evolve in line with the recent downward shift in market expectations for the future path for oil and gas prices (Chart 4). This is recognised in the risk assessment of the January ECB monetary policy statement. It is also reflected in the Consensus expectations of external experts, which are below the December 2023 Eurosystem staff projections in the near term (Chart 9). Work by ECB staff (Lenza et al. (2023) – using a machine‑learning approach with about 60 variables, weighted according to their track record – also points to the possibility of outturns below the December projections. That said, it is worth emphasising that the confidence bands associated with the analysis are very wide, which cautions against putting too much weight on the centre of the distribution.
(annual percentage changes)
Sources: Eurostat, December 2023 Eurosystem staff projections, Consensus Economics and ECB calculations.
Notes: Cut-off date for the random forest is 1 February 2024. Consensus Economics data were collected on 8 January 2024. Random forest estimates are from Lenza, M., Moutachaker, I. and Paredes, J. (2023), “Forecasting euro area inflation with machine learning models”, Research Bulletin, No 112, ECB. The latest observations are for January 2024 (flash).
The broad range of underlying inflation measures have come down substantially from their peaks and also fell in December, reflecting the fading impact of past shocks and weaker demand, including due to the ongoing strong transmission of tighter monetary policy (Chart 10). However, while at a general level, measures of underlying inflation are meant to capture the persistent component of inflation and therefore send signals about medium-term inflation, the relative price shocks that have been triggered by the scale and breadth of the energy shock and the pandemic- and war-related shocks mean that standard measures of contemporaneous underlying inflation may, in fact, not send reliable signals about medium-term inflation dynamics.
Making an adjustment for the impact of energy costs and supply bottlenecks on core inflation deliver measures that peaked at lower levels. The difference between the adjusted and standards measures of underlying inflation suggests that the temporary factors amounted to at least two and a half percentage points at the peak. There is still around one per cent of temporary factors in the unadjusted measures as of now, but the difference is fading out gradually. In addition, this adjustment technique does not correct for the additional pricing power of firms in contact-intensive services during the pandemic reopening phase. To the extent that this effect is also fading out, further deceleration in underlying inflation can be expected.
Measures of underlying inflation
(annualised three-month-on-three-month percentage changes)
Sources: Eurostat and ECB calculations.
Notes: Calculated using seasonally adjusted data. The dashed line corresponds to services adjusted for the effects of the €9 and €49 tickets introduced in Germany in June 2022 and May 2023 respectively.
The latest observations are for January 2024 (flash) for food, energy and goods, December 2023 for the rest. Missing data points for January 2024 will become available with the HICP release on 22 February 2024.
Momentum indicators have eased further for headline inflation and all of its components (Chart 11). The annualised three-month-on-three-month growth rate of seasonally-adjusted HICPX stand at 1.4 per cent, with momentum in goods inflation at zero and momentum in services inflation close to 2 per cent, while the momentum of food inflation is around 3 per cent.
Taken at face value, these readings might be interpreted as challenging the medium-term forecast. However, according to the staff projections, several factors are expected to raise momentum in the coming months, for both headline and core inflation. First, the windfall of plunging input costs through lower energy costs and lower intermediate prices, which may have temporarily muted the need for firms to raise prices is expected to level out. This, in turn, means that rising wage costs (even at the decelerating rate foreseen in the projections) will exert stronger upward pressure on overall costs. Second, the projections foresee a recovery in domestic and external demand this year. All else equal, this will increase pricing power compared to last year. Third, many of the fiscal measures that leaned against strong price pressures in 2022 are scheduled to expire, which will act to push up prices in the near term. This combination of factors explains why the overall trajectory of inflation in the December 2023 projections only converges to the target in the second half of 2025.
In assessing the wage data, compensation per employee from the national accounts provides the most comprehensive measure (Chart 12). However, these data become available only with a lag of over two months. According to the December 2023 Eurosystem staff macroeconomic projections, euro area wage growth is expected to have peaked in 2023 but to remain above the medium-term steady state level during 2024 and 2025, reflecting the ongoing gradual correction of the real wage gap that was generated by the 2021-2022 inflation surge, together with robust labour markets.
Growth in compensation per employee edged downward to 5.3 per cent in 2023Q3 from 5.5 per cent in the previous two quarters. Forward-looking wage trackers provide timely and higher-frequency complements to the official wage data releases and may act as leading indicators for the subsequent releases of the official compensation per employee data. One important indicator from the wage tracker is average wage growth for twelve months ahead, as embedded in agreements reached in the latest quarter (Chart 13). This indicator also gradually edged down in the second half of 2023. Many wage agreements will be renewed in the early months of 2024, and updates to the wage trackers will provide essential information in projecting wage dynamics.
Indicators of euro area wage growth
Euro area wage tracker
The available survey indicators are broadly consistent with the decreasing wage profile foreseen in the latest Eurosystem staff projections (Chart 14). According to our most recent discussions with large European non-financial corporations, the wage growth expectations of this set of companies for 2024 are 4.4 percent on average, which is a marked easing compared to the average 2023 wage growth of 5.3 per cent. Similarly, in the ECB’s latest Survey of Professional Forecasters (SPF), expectations for annual growth in compensation per employee point to a gradual decline in wage growth looking ahead and were revised down over the longer horizon. While expectations are only slightly below that forecasted for 2024 in the December 2023 BMPE round (by 0.15 percentage points), SPF respondents expect a much faster decline in wage pressures in 2025 and 2026.
Survey-based wage expectations and the December 2023 Eurosystem staff macroeconomic projections
Finally, progress along the disinflationary path will also depend on firms buffering rising labour costs with a slowdown in profit growth. Since the aggregate level of profits surged in 2021-2022, there is some room for profit compression without driving profitability to below-average levels (Chart 15). The contribution of unit profits to domestic price pressures continued to fall in the third quarter of 2023, suggesting that unit profits are absorbing some of the price pressures coming from rising unit labour costs. The profit margin proxies derived from the responses to recent corporate telephone surveys also suggest that this buffering process is at work (Chart 16).
SAFE-ORBIS profit margins
Finally, a successful disinflation process requires inflation expectations to be anchored at the two-per cent target over the long term. Taking a longer view, following the protracted period of below-target inflation, between the middle of 2021 and early 2022, there was a remarkable shift in long-term inflation expectations, with survey respondents moving away from long-held views that inflation would indefinitely remain below the two per cent target (Chart 17). While there certainly was a marked increase in the fraction of survey respondents that expected inflation to remain above target in the long term, the majority of respondents assessed that the inflation shock served to re-anchor long-term inflation expectations at the target by demonstrating that inflation risks were two-sided. In turn, reinforced by the target-consistent monetary policy decisions during this period, the stabilisation of inflation expectations has provided an important anchor in the disinflation process.
In this respect, it is encouraging that measures of shorter-term inflation expectations have come down markedly more recently, while measures of longer-term inflation expectations mostly stand around 2 per cent. In particular, the inflation expectations of professional forecasters have moved down over the entire horizon, with longer-term expectations now standing at 2.0 per cent (Chart 18). Similarly, while the expectations component contained in market-based measures of inflation compensation, such as the five-year-in-five-years inflation-linked swaps, has remained anchored at two per cent throughout the inflation episode, it is notable that risk premia have receded over recent months (Chart 19).
Evolution of long-run inflation expectations over survey rounds
Professional forecasters’ inflation expectations
Decomposition of 5-year-in-5-years inflation-linked swap rate
Let me conclude. The declining trend in underlying inflation has continued, and our past interest rate increases keep being transmitted forcefully into financing conditions. By tightening financing conditions, the restrictive monetary policy stance is dampening demand, and this is helping to push down inflation and stabilise inflation expectations.
The December 2023 Eurosystem staff projections see inflation stabilising around the two per cent target from about the middle of 2025 onwards. The incoming data suggest that the process of disinflation in the near term in fact may run faster than previously expected, although the implications for medium-term inflation are less clear. At the same time, the strength of the recovery of the economy, the path of fiscal policies, wage developments, and the degree to which firms absorb higher input costs, all in a context of continued heightened geopolitical uncertainty, will have an important bearing on the inflation trajectory. The March 2024 ECB staff macroeconomic projections will provide the opportunity for a comprehensive update of our medium-term inflation outlook.
We will continue to follow a firmly data-dependent approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. In this process, monetary policy needs to carefully balance the risk of overtightening by keeping rates too high for too long against the risk of prematurely moving away from the hold-steady position that we have been in since September. In terms of an overall evaluation of our policy trajectory, we need to be further along in the disinflation process before we can be sufficiently confident that inflation will hit the target in a timely manner and settle at target sustainably.
I am grateful to Katalin Bodnár, Malin Andersson, Colm Bates, Anna Beschin, Cristina Checherita-Westphal, Andrea Fabbri, Anna-Camilla Hofmann-Drahonsky, Eliza Lis, Aurora Monza, Flavie Rousseau and Fabian Schupp for their contributions to this speech.
See Chahad, M., Hofmann-Drahonsky, A.-C., Page, A. and Tirpák, M. (2023), “An updated assessment of short-term inflation projections by Eurosystem and ECB staff”, Economic Bulletin, Issue 1/2023, ECB and Chadad, M., Hofmann-Drahonsky, A.-C., Meunier, B., Page, A. and Tirpák, M. (2022): What explains recent errors in the inflation projections of Eurosystem and ECB staff?, Economic Bulletin, Issue 3/2022.
I thank the BIS for generous sharing of data. These charts build on the original analysis in the 2023 BIS Annual Economic Report.
Lenza, M., Moutachaker, I. and Paredes, J. (2023): Forecasting euro area inflation with machine learning models, ECB Research Bulletin No. 112.
Headline inflation is noisy since it is affected by the short-term volatility induced by temporary idiosyncratic shocks, thereby blurring the signal about medium-term inflationary pressure that is relevant for monetary policy. Thus, central banks monitor measures of underlying inflation in order to distinguish signal from noise in the data. See Lane, P. R. (2022): Inflation Diagnostics, ECB Blog, 25 November 2022. and Bánbura, M., Bobeica, E., Bodnár, K., Fagandini, B, Healy, P. and Paredes, J. (2023): Underlying inflation measures: an analytical guide for the euro area, ECB Economic Bulletin, Issue 5/2023.
See Bánbura, M., Bobeica, E., Bodnár, K., Fagandini, B, Healy, P. and Paredes, J. (2023): Underlying inflation measures: an analytical guide for the euro area, ECB Economic Bulletin, Issue 5/2023; Lane, P. R. (2022): Inflation Diagnostics, ECB Blog, 25 November 2022. and Lane, P. R. (2023): Underlying inflation, Lecture at Trinity College Dublin, 6 March 2023.
Legislated increases in minimum wages are an important part of the adjustment process.
Wage trackers focus on negotiated wages. While compensation per employee also reflects other factors, the differential between the two (primarily the “wage drift” term) has weakened in recent months.
The wages offered in job vacancy notices provide an additional leading indicator, since the outside option of looking for a new job is relevant in the wage bargaining process. The associated wage tracker produced by the collaboration between Indeed and the Central Bank of Ireland provides an important perspective on this dimension. See Adrjan, P. and Lydon, R. (2022): Wage Growth in Europe: Evidence From Job Ads. Central Bank of Ireland Economic Letter Vol. 2022, No. 7.
These figures are based on the mid-points of the reported ranges.
Consumer inflation expectations and perceptions have overall declined in recent months, even if expectations three years ahead edged up in the most recent release. In general, some volatility in the distribution of household inflation expectations can be interpreted as inescapable, although persistent and material shifts away from the neighbourhood of the target warrant careful monitoring.
Monetary policy ultimately has to be calibrated vis-à-vis the underlying equilibrium rate of interest. For a recent update of estimates of the natural rate of interest in the euro area, see C. Brand, N. Lisack and F. Mazelis, “Estimates of the natural interest rate for the euro area - an update”, Economic Bulletin, Box 7, Issue 1, ECB, 2024.