More Pain Ahead
The February HICP report suggests that there is more pain ahead. Our models suggest that the distribution of price changes continues to shift higher, that the median remains elevated, and that the “common component” across items is increasing. The only good news is that the aggregate core HICP figure (estimated at 7% at annual rate) is probably a bit distorted on the upside by item-specific shocks that should not persist. Still, we are facing a very persistent process and it is hard to imagine an immediate drop. At some point, we will have signs of disinflation and we will start travelling down. But for the time being, the next few months should bring additional elevated MoM readings, likely above the ECB staff expectations.
“Acquired” inflation in 2023
Mechanically, today’s report implies that “acquired” inflation in 2023 is 3.6% for core HICP and 4.5% for headline HICP. (reminder: this means that if the MoM will be 0% in each of the remaining months of 2023, at the end of the year the YoY of core and headline inflation will average 3.6% and 4.5%, respectively). The reader can easily understand that the ECB staff forecast is too low: we still have 10 reports in 2023, core prices are expanding at about 6/7% (ar) and acquired inflation is already 3.6% for core and 4.5% for headline against the ECB staff forecasts of 4.6% and 5.3%, respectively.
Evidence from the distributions
The distribution: higher it goes. This month, most percentiles of the distribution (not shown for brevity, available upon request) moved down. However, as for core CPI in the US, the percentiles are comparable to the December level so there is probably little signal in today’s move. Indeed, Figure 1 and 2 show that the distribution of price changes in the last few months continues to travel to the right (higher). This is possibly the strongest signal that disinflating the Euroarea economy will be more complicated than the ECB assumes. In our experience, the distribution needs first to stabilize (the “plateau” of inflation), then it can (maybe) start travelling back. But this process does not happen in one month or two, it takes several months (if not quarters). Therefore, given such a distribution, the most likely outcome for the next 2-3 months is to get MoM readings of 0.4%-0.5% (that is more than the double of what is implied by the ECB staff forecast).
Last month we wrote: “There is no reason to minimize what it is happening in the Euro area, it is terrible at this point“. Unfortunately, we were not wrong, especially because it seems that the monetary authority keeps underestimating the issue.
Figure 1. Kernel of HICP excluding food and energy items changes (%, a.r.)
Figure 2. Percentiles and Standard Deviation of the distribution of MoM changes (HICP prices excluding food and energy items, % a.r.)
Figure 3. Median HICP price increase
Evidence from our CI-C model
Our CI-C model estimates that net of Covid and idiosyncratic shocks, the common component across items in February was solid and higher than in the previous months. Figure 4 shows the decomposition of the MoM of core HICP in the “common” component, the “idiosyncratic” component, and the “Covid” effect. The model estimates that in February the common component increased by 17bps, higher than the previous months. The Covid effect is estimated at 28bps, and the idiosyncratic shock is positive (10bps). Given the size of the idiosyncratic shock this month, it is fair to say that the MoM of core HICP (56bps in our estimates) was probably a bit distorted to the upside, with the “true” signal a few basis points lower.
Figure 4. Contributions to MoM changes of HICP excluding food and energy items
Note: the Figure shows the decomposition of the MoM percent changes of HICP prices excluding food and energy items. The contributions are estimated using our CI-C model, a 2-stage OLS-LASSO regression model. The “Covid” effect is identified with price variations outside the 10th-90th percentiles of each item pre-Covid price change distribution.
Figure 5. Estimated “Common” component: YoY, 3m/3m a.r. and 6m/6m a.r.
Note: the Figure shows the 3m/3m at annual rate (green line), the 6m/6m at annual rate (red line), and the YoY (blue line) of the “common component” estimated using our CI-C model.
Implications for the medium-term forecast of core HICP
The medium-term forecast of core HICP is little changed as the final release was close to the flash estimate. According to the model, core HICP is forecasted at 5.2% (Q4/Q4) in 2023 (average of four quarters at 5.4%), 3.9% in 2024, and 3.6% in 2025.
Note: the confidence intervals (C.I.) are calculated using the estimated parameters distributions.
First quarter of forecast: 2023:Q2.
Implications for the ECB staff and the Governing Council
We have already commented yesterday’s Governing Council Meeting (here).
For the time being, it is pretty clear in our view and estimates that the next few months will not bring many good news to Frankfurt.