VoxEU has published an article titled “Understanding inflation risks in the US and the euro area”.
Please, find below our review and comments.
To keep in mind
The model of the authors suggests that, since the onset of the pandemic, the trend component of inflation has risen in both the US and the euro area by a similar amount – approximately 75 basis points. However, in the US, this rise has taken the trend well above the 2% target, whereas in the euro area it is still slightly below the target, at 1.7%.
What the paper does
The authors estimate the level of underlying inflation for the US and the Euro area using the model proposed by Hasenzagl et al. (2020, 2021). The model is an unobserved component model that starts from headline CPI inflation and estimates underlying as the trend of the series, net of cyclical contributions (slack) and energy prices. The model defines the trend as the component of inflation that is not due to cyclical components and that is reflected in professionals’ and consumers’ medium-term forecasts of inflation.
Results
The model estimates that (unsurprisingly) most of the variation of headline inflation is driven by energy price disturbances and that the contributions of slack are small in both jurisdictions. The model suggests that, since the onset of the pandemic, the trend component of inflation has risen in both the US and the euro area by a similar amount – approximately 75 basis points (see Figure 1 of the paper – reported here below). However, in the US, this rise has taken the trend well above the 2% target, whereas in the euro area it is still slightly below the target, at 1.7%. Finally, according to the model, in a year from now euro area HICP inflation will still be below the 2% target, at 1.75%, while in the US CPI inflation will be above, at 2.75%.
Comment
The analysis is run on headline CPI/HICP, therefore it is closer to the ECB staff approach than to the Fed staff approach.
Starting with the US, the model estimates a level of underlying inflation close to 2% before Covid while in our view the Fed staff was estimating a level of underlying inflation significantly below 2% in core PCE space. While the difference seems small, it was the entire point of the Fed strategy review so it is unclear why the authors run the model on CPI data for the US rather than in PCE space. The authors’ model delivers a current estimate of underlying inflation of 2¾ percent for the US. This estimate is in line with our own set of trend inflation models which are currently suggesting a level of trend inflation of 2.3 percent in core PCE space (the difference between the authors’ estimates and our own can be attributed to the usual 0.3-ish CPI-PCE gap).
Switching to the Euro area, the authors’ model estimates a level of underlying inflation around 1 percent before Covid. While we still do not maintain a formal set of models for the Euro area, the authors’ pre-Covid estimate is nearly identical to the one we would write down. As for the Covid period, the author’s model appears to be influenced by the current increase in core HICP. However, in our view, the core HICP numbers are currently distorted by base effects and by the re-introduction of the VAT in Germany. For this reason, we think that the authors’ results are also distorted in the Covid-sample, and that a more realistic level of underlying inflation for the euro area remains closer to 1 percent.
Implications for the Fed/ECB staff
In our view, the Fed Board staff has read this analysis but with no particular interest because the level of underlying inflation in the staff decomposition is judgmental and based on a different procedure (the three pillars: measures of trend inflation, measures of long-term inflation expectations, and the general equilibrium approach). On the other hand, in our view the ECB staff has taken the authors’ analysis as a confirmation of the latest ECB projections (in which core HICP is expected to converge to 1.8% at the end of the medium-term). All told, we think that the risks around the authors’ estimates are well balanced for the US but that they are skewed to the downside for the euro area.