Disinflation in the euro area: an update

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the University College Dublin Economics Society

Dublin, 15 April 2024

My aim today is to review the recent evolution of inflation in the euro area, together with the implications for monetary policy. The ECB has held the main policy rate (the deposit facility rate) at 4.0 per cent since last September. At last week’s Governing Council meeting, we indicated that, if our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission were to further increase our confidence that inflation is converging to our target in a sustained manner, it would be appropriate to reduce the current level of monetary policy restriction.^[1]

Chart 1 shows the evolution of headline and core inflation since 2019^[2]. Let me focus on the disinflation patterns since August 2023. Inflation stood at 5.2 per cent last August and has subsequently declined to 2.4 percent in March. Energy inflation has moved from -3.3 per cent last August to -1.8 per cent in March; food inflation has declined from 9.7 per cent to 2.7 per cent; and core inflation has fallen from 5.3 per cent to 2.9 per cent. Looking at the individual subcomponents of core inflation, there has been a reduction in goods inflation from 4.7 per cent to 1.1 per cent, and in services inflation from 5.5 per cent to 4.0 per cent.

Chart 1

Headline inflation and core inflation

Annual percentage changes

In terms of the array of underlying inflation measures tracked by the ECB, Chart 2 shows the evolution of the refined versions of these measures, which adjust for the dynamic impact of energy shocks and supply bottlenecks.^[3] The improvements in these measures since August 2023 suggest that the observed disinflation has a substantial persistent component. At the same time, there has been much less progress in relation to domestic inflation compared to broader inflation measures, reflecting the higher sensitivity of domestic inflation to local cost pressures. As captured in Chart 3, the overall disinflation rate largely reflects the unwinding of the supply shocks that were the primary source of the inflation surge in 2021-2022.

Chart 2

Adjusted measures of underlying inflation

Annual percentage changes

Chart 3

Sources of annual price inflation in the euro area

Annual percentage changes and percentage point contributions

The role of monetary policy in the disinflation process has been to ensure that the large and persistent but temporary inflation shocks did not mutate into an increase in the medium-term inflation trend through the de-anchoring of inflation expectations. Since 2022, the central tendency distribution of longer-term inflation expectations has remained largely centred at the two percent target, reflecting the general credibility of the ECB’s commitment to delivering its inflation target.^[4] Since last summer, a range of measures show that near-term inflation expectations have also come down and that the risk of inflation staying above target in the long term has diminished. Charts 4 to 8 shows the evolution of various indicators of inflation expectations and inflation risk: Chart 4 shows the right tail in the distribution of long-term inflation expectations in the Survey of Professional Forecasters has markedly diminished compared to the peak inflation phase in late 2022; Chart 5 shows that the inflation risk premium embedded in five-year-on-five-year inflation swaps has declined by about 40 basis points since last summer; Chart 6 shows that the option-implied probability of above 2.5 per cent inflation in the five-year-on-five-year interval has dropped, while the option-implied probability of below 1.5 per cent inflation has picked up; Chart 7 shows that, according to the Consumer Expectations Survey, households have recognised the improvement in inflation outcomes and marked down their near-term inflation expectations; finally, Chart 8 shows that, according to the results from the survey on the access to finance of enterprises (SAFE), firms have lowered their near-term inflation expectations, while the proportion of firms that fear high inflation in the medium term has decreased.^[5]

Chart 4

Survey of Professional Forecasters (SPF): distribution of longer-term inflation expectations

Percentage of respondents

Chart 5

Decomposition of five-year-in-five-year inflation-linked swap (ILS) rate

Annual percentage changes

Chart 6

Option-implied probabilities of inflation outcomes

Percentages

Chart 7

ECB consumer expectations survey

Annual percentage changes

Chart 8

Firms’ expectations about euro area inflation at different horizons

Percentages per annum

The lowering of perceived inflation risk is plausibly connected to the faster-than-expected decline in inflation in recent months, which has provided reassurance that inflation would not remain too far away from target for too long. This is captured in Chart 9, which shows the evolution of the projected 2024 inflation rate over the September, December and March projection rounds. Chart 10 also shows the downward revisions to the 2024 growth rate over these projection rounds.

Chart 9

Inflation in 2024

Annual percentage changes

Chart 10

Real GDP growth in 2024

Annual percentage changes

Despite the overall disinflation trend, services inflation remains high at 4.0 per cent. The decline in services inflation since last summer has largely been in non-labour-intensive services sectors, reflecting the indirect impact of lower energy prices, the easing of supply bottlenecks and the fading out of pandemic reopening effects on these sectors. As shown in Chart 11, there is a relatively tight medium-term relation between wage inflation and the inflation rate for labour-intensive services sectors (which make up a large part of the domestic inflation component). Over time, deceleration in wage growth is necessary in order for services inflation to converge to a rate that is consistent with meeting the two per cent target for overall inflation.

Chart 11

Services inflation developments

Annual percentage changes

Wage pressures are gradually moderating but remain elevated compared to a steady-state benchmark. As shown in Chart 12, annual growth in compensation per employee decelerated in the fourth quarter of last year to 4.6 per cent, from 5.1 per cent in the third quarter. Growth in compensation per hour also slowed, falling in annual terms to 4.4 per cent in the fourth quarter from 5.0 per cent in the third quarter. The wages and salaries component of the labour cost indicator decreased to 3.3 per cent in the fourth quarter from 5.1 per cent in the third quarter. Annual unit labour cost growth fell to 5.8 per cent, from 6.5 per cent, but remained high, in part reflecting weak productivity growth. Negotiated wage growth including one-off payments also declined further, falling to 3.2 per cent in January from 4.8 per cent in December, although this figure does not yet include the data for France and Italy.

Chart 12

Labour cost indicators

Annual percentage changes and percentage point contributions

As shown in Chart 13, forward-looking wage trackers also continue to provide signs of easing. As shown in Charts 14 and 15, the feedback from firms participating in the Corporate Telephone Survey (CTS) and the SAFE point to lower wage growth this year. The March projections foresee subsequent phases of further wage deceleration in 2025 and 2026, with the growth rate of compensation per employee declining from 5.3 per cent in 2023 to 4.5 per cent in 2024, 3.6 per cent in 2025 and 3.0 per cent in 2026.

Chart 13

Wage trackers

Annual percentage changes

Chart 14

CTS wage expectations

Number of responses

Chart 15

SAFE wage expectations for one year ahead

Percentage changes over the next 12 months

In addition to wage growth deceleration, the convergence of inflation to the target also requires compression in profits. As reflected in Chart 16, annual growth in unit profits decelerated further in the fourth quarter, falling to 2.8 per cent from 4.7 per cent in the third quarter. This significant decline was the main driver of the reduction in the annual growth rate of the GDP deflator, which fell by 0.6 percentage points to 5.3 per cent. As embedded in the March projections exercise, further compression in profits is required to support the convergence of inflation to the target, and a sufficiently restrictive monetary policy stance is necessary to provide the dampened demand conditions to limit the pass-through of rising costs to consumer prices.

Chart 16

GDP deflator

Annual percentage changes and percentage point contributions

In monitoring the transmission of the monetary policy stance, Chart 17 records the policy rate time series (together with the market-priced forward path) and Chart 18 the contraction in the Eurosystem balance sheet; Chart 19 depicts the evolution of the risk-free yield curve; Chart 20 plots bank lending rates for firms and households; Charts 21 and 22 report credit standards for firms and households; finally, Charts 23 and 24 report credit volumes for firms and households.

Chart 17

€STR forward curve and deposit facility rate (DFR); APP, PEPP and TLTROs

Percentages per annum

Chart 18

APP, PEPP and TLTROs

Trillion euros

Chart 19

Euro area Overnight Index Swap (OIS) yield curve

annual percentages

Chart 20

Lending rates for new and outstanding amounts: firms and households for house purchase

percentages per annum

Chart 21

Change in credit standards and demand for loans to firms, and contributing factors

net percentages of banks

Chart 22

Change in credit standards and demand for loans to households for house purchase, and contributing factors

net percentages of banks

Chart 23

Net debt financing flows of euro area firms

left scale: average monthly flows, in EUR billions; right scale: annual percentage changes

Chart 24

Bank loans to households

left scale: average monthly flows, in EUR billions; right scale: annual percentage changes

Finally, it should be recognised that the current phase of disinflation is necessarily bumpy. In particular, the swings in energy prices during 2023 will generate oscillations in base effects in the monthly inflation readings, while the staggered reversal of various temporary fiscal supports will also operate on the price level in an uneven manner. Chart 25 plots a range of indicators of near-term inflation dynamics and the projected quarterly evolution of headline and core inflation according to the March projections. Headline inflation is expected to fluctuate around current levels in the near term on account of base effects in the energy component and the reversal of the upward effect of the early timing of Easter on services inflation in March. While services inflation should decline somewhat in the near term, it is expected to remain relatively elevated for most of this year.

Chart 25

Short-term forecasts for HICP (left) and HICPX (right)

Annual percentage changes

Even if the near-term inflation outlook is somewhat bumpy, the projected convergence of inflation to the target in 2025 will be underpinned by: the lowering of labour cost pressures; some additional compression of unit profits; the dissipation of the adverse effects of past energy shocks, supply bottlenecks and the pandemic re-opening; and the further unfolding of the disinflationary impact of the restrictive monetary policy stance. This disinflationary dynamic is consistent with both inflation stabilising at our target in 2025 and a substantial economic recovery, with rising real incomes and improvements in the terms of trade, together with the prospect of dis-inflation unlocking future interest rate reductions, boosting domestic consumption and investment, while the normalisation of foreign demand will facilitate growth in exports.

This review of the disinflation path in recent months and the analysis of the drivers of inflation over the projection horizon indicate that, based on the three elements of our reaction function we can conclude that the key ECB interest rates are at levels that are making a substantial contribution to the ongoing disinflation process. Our future decisions will ensure that our policy rates will stay sufficiently restrictive for as long as necessary. If our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission were to further increase our confidence that inflation is converging to our target in a sustained manner, it would be appropriate to reduce the current level of monetary policy restriction. In informing this assessment, the June Governing Council meeting will benefit from updated staff projections and the accumulation of data about the dynamics of wages and profits in the opening months of this year. In any event, we will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction, and we are not pre-committing to a particular rate path.