It’s over. With that, I mean the danger of deflation, or low inflation. It is highly likely that inflation will rise in the first months of 2016. Why? It has to do with the oil price, mathematics and the way in which inflation is calculated.
There are no words to describe the oil price drop between June 2014 and January 2015. For simplicity’s sake let’s say it was spectacular. The price of a barrel of oil plunged: from approximately 115 dollars in the summer of 2014, to about 45 dollars earlier this year.
Considering the importance of energy in our economies it is no miracle that, in conjunction with the oil price, inflation also declined. While inflation was still more than 1 percent in the spring of 2014, it dropped to below 1 percent after the oil price drop. Over time, it declined to 0 percent, and in some particular months it even declined to levels below 0 percent.
If we look beyond the so-called headline inflation, and take a deeper look into inflation rates, then we’ll see that the drop was caused by one single subcategory: energy prices. Starting from May this year, it is the only subcategory of which the price is declining (September being the only exception: tobacco prices declined by 0.2 percent). The drop was so substantial that, depending on the month, prices declined between 4.8 and 8.9 percent. It essentially dragged the entire inflation rate down along with it.
At the start of January 2016, it will be exactly one year ago that the oil price started to recover after the earlier mentioned decline. And this gives lead to the next important topic: how the inflation rate is calculated.
The inflation rate is calculated by taking the difference between the prices of several goods and services, comparing their prices with those of twelve months ago. I wasn’t surprised that the inflation rate starting the summer of last year, as well as this year, quickly dropped to 0 percent. After all, statisticians compared current energy prices with the prices of a year earlier. And as energy prices are closely linked to oil prices, experiencing a sharp decline, the inflation rate was dragged along. And since it also has a strong weight in the basket of goods compromising the inflation rate, the monthly reported inflation rate dropped correspondingly fast.
From early 2016 onwards, statisticians will, for the first time since the oil price drop, be faced with an insignificant influence of the energy prices (their prices will not have changed much relative to last year). The reason is clear: when comparing an oil price of, let’s say: 50 dollars, with an oil price of 50 dollars, then the price change is 0 percent.
What does that mean for the monthly inflation figures published by Eurostat? That the strong downwards pressure asserted by energy prices are fading away. What does that mean for the monthly report? That inflation will at least be 1 percent, or slightly above. Why? Because that was the rate of inflation from the start of this year, excluding the spectacular fall of energy prices.
The oil price doesn’t have to rise in the coming months to boost the inflation rate in the euro area. On the contrary, the oil price may even decline a little bit and inflation would still rise. Don’t forget that we are talking about a price comparison of the current oil price compared to last year’s. The euro area inflation rate would only drop if the oil price would halve from its current level. Only then would there be a similar effect on the inflation rate. And if the oil price were to rise, inflation would be hit with a double whammy and rise spectacularly. It may very well be possible that inflation in the Eurozone will approach 2 percent. This would make the ECB very happy. But they would probably be the only one.