Eurozone: The Last Mile, Price Persistence and the Supplies Surprise

Figure 1: Price Persistent Recedes as Supply Improves

Source: ECB, Fed Reserve Bank of New York

The Last Mile

And as the ECB meeting in December then noted that when looking at the annual inflation data for the last few years, it appeared that disinflation to date had actually been faster than the previous surge in inflation, questioning the empirical relevance of the “last mile” narrative that many central bankers have been highlighting. Indeed, this has continued as headline HICP inflation has fallen at around 0.5 ppt per months since the peak in late 2022, some 0.1 ppt pm faster than the previous surge.  The notion of a difficult “last mile” has been put forward, most notably by ECB hawks.  They argue that inflation when its starts to fall may do so fairly rapidly, at least to begin with as largely supply-driven base effects fall out of the y/y measures of price changes.  Of course, as we have argued, the best way to overcome such issues it to look as more short-term seasonally adjusted measures of inflation, something that the more dovish ECB members are now doing.  Regardless, it also not clear why the nature of the disinflationary process would change as any particular target or inflation rate drew closer. As such this questions the empirical relevance of the “last mile” narrative, not least as the disappearing ‘largely supply-driven base effects’ are replaced by demand factors.

Clearer Softer Price Dynamics

This is even more the case given the recent more encouraging signs regarding EZ underlying inflation.  This continued in the January HICP numbers, albeit with the 0.1 ppt drops in both headline and core being less that most anticipated. Even so, the headline, at 2.8%, resumed its recent decline while the core fell a notch to 3.3%, a 22-month low and very much on course to meet the ECB Q1 projection of 3.1%, if not undershoot it.  The ECB may be somewhat troubled by the failure of services inflation to have fallen in the last few months, this stable 4.0% y/y reading also evident in more resilient but still more modest m/m adjusted numbers. But this we feel is a result of fiscal measures rather than clear signs of price resilience

Regardless, we still envisage that the headline will now hit if not undershoot target before mid-2024, well over a year earlier than the ECB envisages, while the core should continue to fall in the interim regardless.  But  as suggested above, this disguises an even clearer fall in recent price dynamics, as seen in m/m seasonally adjusted data and with the smoothed core rate now consistent with an undershoot of the 2% target, albeit possibly stabilizing at around 0.1% in m/m terms.  However, the ECB instead continues to (at least overtly) focus on y/y rates despite the ensuing limitations from spurious base effects, although the adjusted data is widely used by the likes of Chief Economist Lane and was clearly mentioned in the minutes to the last ECB meeting.  Even so, it does seem as if the ECB is letting its inflation analysis be affected as much (if not more) by developments that happened up to 12 months ago rather than in the last month or so. 

Figure 2: PCCI as a Lead Indicator

Source: ECB

Assessing Persistent Price Pressures

Regardless, even on a somewhat dated y/y basis, there are ever-clearer signs of softer underlying inflation most notably in terms of non-energy goods but also in terms of persistent price pressures which are now running below the 2% target.  It is this latter gauge which we follow and which is now clearly a measure that the likes of ECB Chief Economist Lane also favors has shown further signs of slowing (Figure 1), actually suggesting below target price pressures at the core level.  But this Persistent and Common Component of Inflation (PCCI) measure also offers lead properties, having repeatedly foreshadowed HICP inflation turning points in the past (Figure 2). An added reassurance comes from the fact that its recent slowing is an indication that price pressures are not broadening out, the very opposite. This is because the PCCI captures widespread developments across the HICP basket that are persistent (hence the name), this being all more crucial as the ECB hawks apparent focus is on preventing the recent inflation surge becoming embedded.

 Backed up by Other Reassuring Signs

Even the ECB acknowledges that supply bottlenecks are gradually easing, although it justifiably contends that their effects are still contributing to inflation.  But there are clearly more reassuring  signs, particularly now that the combination of slowing demand and improved supply has led to companies asserting that inventory levels are now back to normal, if not actually above-normal.  This is likely to mean that already easing PPI inflation falls further and possibly appreciably so (Figure 3). 

Admittedly, there are some signs of fresh supply pressures, most notable in construction where the latest PMI survey reading pointed to the most substantial fall in activity since May 2020. However, while firms highlighted a steep lengthening in delivery times in January for the first time in nine months amid delivery delays and difficulty sourcing materials, cost pressures remained historically subdued, while employment levels were scaled back to the softest extent since last August. This mirrors other survey data showing that especially in services, while firms are reporting employee shortages, they are increasingly reluctant to recruit!

Figure 3: Replenished Inventories Highlight Easing In Supply Shortages

Source: Eurostat, European Commission

Global Supply Swings

But perhaps a global supply indicator would offer broader signs of supply pressures easing, something provided by the Federal Reserve Bank of New York Global Supply Chain Pressure Index, this being an aggregation of private sector cost and supply gauges.  Indeed, on this measure the supply situation is back to pre-pandemic levels, possibly explaining the sustained low inflation seen in the years after the GFC.  As Figure 4 shows, it correlates well with EZ HICP core inflation, both pre-pandemic and more recently, most notably when lagged (by some 15 months in the chart).  But the correlation- and we would argue causation - is even clearer for this supply index when tracked against persistent core inflation as is shown in Figure 1, where the same lags are applied.

Figure 4: Core Inflation Recedes as Supply Improves

Source: Eurostat, Fed Reserve Bank of New York

Demand Disinflation Ahead

This very much implies that this easing in supply pressures seems to have curtailed what has been the main worry of the likes of the ECB, ie persistent price pressures. This suggest that unless supply pressures return (we think the Red Sea situation poses only very modest risks in the direction while the lead indicator properties of the PCCI suggest a suggest a sustained turning point has occurred) from here-on inflation will be demand determined.  And with real economy still being hit by ECB conventional hikes, its balance sheet reduction and by banks’ wariness about lending, then a further bout of disinflation lies ahead, albeit from hereon more demand than supply determined!