Eurozone: The great inflation reshuffle - ING Think

Economic and Financial Analysis

14 January 2021
                  Eurozone: The great inflation reshuffle
Article

                  The return of inflation could be one of the biggest surprises in 2021. For the
                  first time since October 2018, headline inflation could actually hit 2% in the
                  third quarter. However, don’t be afraid: hyperinflation is not waiting around
                  the corner

                     Content
                     - Inflation could become a surprise theme of 2021
                     - Drivers of deflation are set to become drivers of reflation
                     - Fundamentals still point to low inflation in the medium term

                  Inflation could become a surprise theme of 2021
                  With negative inflation rates, continuing lockdowns and a gradual economic recovery, the
                  consensus expectation has long been for inflation to be muted this year. In its December staff
                  projections, the European Central Bank forecast a gradual increase in eurozone headline
                  inflation from 0.3% in 1Q to 1.5% in 4Q. While the ECB has developed an impressive track record
                  in overestimating future inflation rates, we would argue that 2021 could be the first year in a
                  long while that inflation will actually outperform the ECB’s own expectations.
                  Headline inflation in the eurozone has been negative since August last year, stirring fears of yet
                  another deflationary spiral and concern that the ECB will have a very hard time ever returning
                  inflation to target. However, a closer look shows that falling inflation rates since January have
                  mainly been the result of one-off factors like the temporary German VAT reduction, lower
                  energy prices and the negative impact from social distancing and lockdowns on certain sectors
                  and prices. All these factors together pushed headline inflation some two percentage points

lower in the second half of 2020.

Inflation at constant taxes has been 0.6% higher since the German VAT cut

Source: Eurostat

More generally speaking, the lockdown measures across the eurozone complicate the proper
measuring of inflation, as some services are simply not available. The pandemic has also
(temporarily) changed lifestyle and spending patterns - changes that are not reflected in the
composition of the price index. This makes the current estimate of inflation more uncertain and
causes increased risk of higher (or lower) inflation than currently reported.

Drivers of deflation are set to become drivers of reflation
The drivers behind negative inflation rates in 2020 will fade in 2021: negative base effects from
low energy prices, falling prices due to social distancing measures and, above all, the German
VAT cut in July. The base effect for energy prices will turn positive in April and the positive base
effect from higher energy prices could bring a positive contribution to eurozone inflation of
some 0.4 percentage points by May, compared to -0.8 percentage points in November 2020.

Energy inflation is set to reverse on strong base effects alone

Source: Eurostat, ING Research calculations

Assuming that governments will start to reopen their economies from the second quarter
onwards, and that this reopening is permanent given the ongoing vaccination programme, a
reversal of the social distancing deflation could push up headline inflation by another 0.5
percentage points. After the first wave lockdowns, price categories specifically impacted by
social distancing (think package holidays and restaurants, in total accounting for some 20% of
the inflation measure) nosedived, as fear of the virus dampened demand more than the
restrictions did on supply. Once the economy reopens, expect this to reverse due to significant
catch-up demand and businesses wanting to make up for lockdown losses.

Prices most affected by social distancing have seen a large decline, expected
to reverse on reopening

Source: ING Research

For more on the social distancing index, please see our previous piece here:
https://think.ing.com/articles/eurozone-ecb-suffers-from-social-distancing/.

Add to this the reversal of the German VAT reduction as well as the introduction of a CO2 tax
and German inflation is likely to come close to and probably even above 2% in the second half
of the year, further adding to upside pressure on eurozone inflation. All in all, even without any
significant change in underlying inflationary pressure, eurozone headline inflation could get

close to 2%.

Fundamentals still point to low inflation in the medium term
With several strong headline inflation readings starting in 2Q, some financial market
participants could get nervous, recalling old fears of accelerating inflation as a result of loose
monetary and fiscal policies. Or at the very least, they could get worried about surprise
tightening by the ECB. Together with the Biden bounce, and a possible reflation of the US
economy, inflation fears could become a surprise topic of 2021.
However, before we get too carried away, remember these inflation fears may well disappear
as quickly as they arrived. After a possible initial euphoria phase, combined with higher base
effects, fundamentals will take over, and they look bleak. With the eurozone economy probably
not reaching pre-crisis levels before 2023, output gaps will remain very high. Unemployment is
expected to remain elevated compared to pre-crisis levels, at best, for 2021, which does not
bode well for wage growth. Collective bargaining agreements over the course of 2020 were
already much weaker than in 2019 and the number of bankruptcies is still set to go up as
support unwinds. Also, the stronger euro puts a cap on inflationary pressures. That makes it
hard to see how inflation is set to be structurally higher than before the coronavirus crisis began
or how one-off factors could lead to unwarranted second round effects. In fact, we expect
headline inflation to fall back to the 1% - 1.5% range in 2022, still clearly below the ECB's target.
Still, higher headline inflation numbers coupled with market speculation about future policy
moves will put the ECB’s communication skills to the test. In this regard, the latest comments
from ECB board member Isabel Schnabel that it “would be the biggest economic policy mistake
that could be made – tightening monetary and fiscal policy too soon” or from the Spanish
Central Bank Governor Hernandez de Cos on possible yield curve control, have already given a
taste of what's to come. Finally, don’t forget that as long as quantitative easing is active, almost
covering the entire supply of government bonds in the eurozone, demand and supply, rather
than inflation expectations will determine the level of bond yields.

Carsten Brzeski
Global Head of Macro
+49 69 27 222 64455
carsten.brzeski@ing.de

Bert Colijn
Senior Economist, Eurozone
+31 20 563 4926
bert.colijn@ing.com

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