You Can Fly Away With Me, HICP
The January HICP report suggests that the situation is getting (much) worse. Our models suggest that in today’s report most percentiles of the distribution shifted up again, that the median jumped to 6% (!) ar (which is in line with the estimated MoM of core HICP itself in January), and that the “common component” across items is stronger than last month. Translated: there is not a single good news for the ECB in today’s report and any effort to minimize what is going on (or even worse labeling it as “it’s all/only supply-driven”) is completely out of touch with reality at this point.
“Acquired” inflation in 2023
ECB staff forecast for core HICP is (way) too low. We have computed the “acquired” inflation for the Euro area in 2023 following the same procedure used by ISTAT for Italy. Mechanically, today’s report implies that “acquired” inflation in 2023 is 3.0% for core HICP and 3.7% for headline HICP. (reminder: this means that if the MoM of core HICP will be 0% in each of the remaining months of 2023, at the end of the year core inflation will be 3.0% as average of the year). The reader can easily understand that the ECB staff forecast is too low: we still have 11 reports in 2023, core prices are expanding at about 6% (ar) and aquired inflation is 3.0%. How can the ECB staff forecast 4.2% for 2023?
Evidence from the distributions
The distribution: higher it goes. This month, most percentiles of the distribution (not shown for brevity, available upon request) moved up again. For instance, the 75th pct increased from 8.3% (ar) to 10.7% (ar), and the 95th pct from 17.9% to 25.8%. The reader can refer to Figure 1 and 2 to appreciate the dramatic (and still on-going) upward shift of the distribution. In our experience, this is not going to stop so easily, especially considering that in January the median (Figure 3) jumped to 6% (ar), the highest value since the beginning of this inflationary episode. There is no reason to minimize what it happening in the Euro area, it is terrible at this point (for the record: not even in the US we have seen such a spectacular move of the distribution, and particularly of the median).
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 January was solid and higher than in December. 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 January the common component increased by 14bps, marginally higher than the previous month. The Covid effect is estimated at 26bps, and the idiosyncratic shock is positive (8bps). We remind that the common component is very persistent by construction and that, as shown in Figure 5, it has gone sideways for several months. Translated: it is not going to be so easy to disinflated the Euro area and it will take time.
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 4.9% (Q4/Q4) in 2023 (average of four quarters at 5.2%), 3.8% in 2024, and 3.5% in 2025. As mentioned, this forecast is very close to the previous run (February 1st).
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
The hope is that the ECB staff and the Governing Council will admit reality. But we fear it will remain a hope. There is no doubt about what is going on in the Euro area. As we wrote, any attempt to minimize the evidence is completely out of touch with reality at this point (as an additional example, please see Figure 6 below that shows recent readings for one of the used-to-be most stable and persistent HICP items). It is also very clear that the ECB staff forecast for core inflation is too low and should be revised up going forward (although the forecast for headline can, indeed, be revised down due to lower energy prices). The ECB staff and the Governing Council have to make a choice. They can either decide to construct a narrative and a policy response around headline HICP (“it’s all energy”) or face reality. We hope they will choose wisely this time because if they go for the former, they will put the seeds for a replay of the 1970s.
Figure 6. HICP Recreation and Personal Care excluding Package Holidays – Metrics
Note: the Figure shows the metrics for HICP Recreation and Personal Care excluding Package Holidays (which tends to be extremely volatile). The 3m/3m and the 6m/6m are calculated using the BEA US National Accounts approach. “ar” stands for “at annual rate”.