16 janvier 2017

European Reflation: Boon or Bane?

January 16, 2017, by Dr. Christian Witt (YCAP Asset Management)

In economic terms, the New Year has started with a bang in Europe: some inflation is back! What is more, inflation has vastly beaten expectations in most major Euro Area economies (see Table 1). True, some of the increase is due to a base effect as energy prices bottomed out about a year ago. However, with inflation surprising to the upside, one needs to consider the possibility that the latest episode of reflation might go beyond a mere rise in energy prices. Perhaps, December 2016 even marks the end of a 3-year period of poor inflation. Of course, the surge in inflation may also be a blip and it is positive from an economic point of view. However, from an investor’s point of view, recent inflation data raises the question: Is European reflation more of a boon or bane?

In a first step, let us examine recent inflation dynamics from various angles. As Figure 1 shows, Euro Area inflation has been close to or even below zero for the better part of the last three years whereas hitherto inflation mostly fluctuated around the ECB’s 2% inflation target (between 1.0% and 3.0%). Thus, the surge in inflation could bring this episode to an end. Moreover, excess inflation––the inflation differential between any given country and the Euro Area average––depicts a stunning regime change going back to the peak of Euro Crisis (see Figure 2). In fact, before 2012, Spain typically had the highest excess inflation and Germany the lowest; but their fortunes have inverted ever since. Meanwhile, Italian excess inflation has gradually turned into the lowest among the major Euro Area economies. Given that Italy and Spain have both been at the epicenter of the Euro Crisis (2010-13), excess inflation seems to be an indirect measure of economic momentum. Finally, our measure of the force of reflation––current inflation relative to the lowest inflation over the preceding 12 months––reveals that the recent spike has been one of the strongest since the creation of the Euro (see Figure 3). By the same measure, we also detect some divergence among countries as reflation has been much stronger in Spain and Germany than in Italy and France (see Figure 4). Thus, current reflation comes at a most peculiar time when inflation dynamics have been anemic and traditional excess inflation inverted.

Against this background, the pressing question becomes how the European Central Bank (ECB) may respond to the evolving new situation? In the short term, the answer is certainly ‘not at all’. For the ECB has committed itself to keeping the current pace of QE until the end of this year. But looking beyond 2017, there are several factors to consider. First, following similar periods of reflation in the past, say in 2007 or 2011, the ECB tended to tighten monetary policy soon after. Hence, one may expect discussions about tapering and raising rates to start soon. Second, the ECB may face an intricate policy conundrum if the divergence in the force of reflation persists (see Figure 4 again); especially with respect to Italy. Take real interest rates for example (see Figure 5). At the moment, Italy is the only major Euro Area economy with positive 10-year real yields––that is, nominal yields less annual consumer inflation. Italian financial conditions accordingly appear excessively restrictive compared to their Euro Area peers. And the disadvantage would most likely grow, if the ECB were forced to raise rates to respond to French, German or Spanish inflation. Italy’s economic underperformance would almost certainly continue under such circumstances. In the worst case, the ECB might even destroy Italy’s financial stability if investors were to doubt the sustainability of public debt under financial tightening. Sovereign yields would soar and Italian banks would likely be next to suffer. Growth prospects would deteriorate; a vicious circle might ensue. As a result, current reflation dynamics are of the utmost importance because the risks associated with tightening monetary policy increase with inflation divergence.

To sum up, the recent surge in inflation is special in various ways: 1) It may bring an end to an exceptionally long period of low inflation that has lasted since 2013; 2) the force of reflation is noticeable; 3) below-average excess inflation and above-average real yields mean Italy is losing ground economically. In this context, it seems likely that discussions about monetary tightening will start soon, most likely in the first half of this year. Meanwhile, the success of monetary tightening may depend on whether inflation differentials in the Euro Area will be substantial or not at the time of implementation. If they are, the risk is that low inflation countries will be penalized by the ECB’s decision. Current data suggests that among large Euro Area economies Italy seems to have the highest chance of being trapped this way. The country’s economy is also most vulnerable under such circumstances. Monetary policy accordingly risks to wreck one of the currency block’s most vital economies. This leads us to conclude that reflation may offer some relief for the Euro Area in the short term; however, in the long term it might turn into a bane if inflation rates continue to diverge.


Table 1: Inflation (HCPI) and Expectations by Country.

Inflation (HCPI)






Euro Area































Figure 1: Inflation Rate, %yoy.

Figure 2: Excess Inflation, %yoy.

Figure 3: Rolling 12-Month Reflation (Current Inflation vs. 12-Month Low) in Percent.

Figure 4: Divergence of Inflation Rates and 10-Year Real Yields.

Figure 5: 10-Year Real Yields in Percent.