Economic Insight: Inflation risks

The outlook on inflation is the most critical factor for future interest rates. Conventional explanations of inflation have failed to give accurate forecasts in recent times. Sharp international competition and digitalization have mitigated the inflationary effect of domestic factors like the decline in unemployment rates and a higher capacity utilization. Against this backdrop, we foresee only moderately higher inflation rates for the next two years in our base case scenario with oil prices at 65 US$ per barrel. Correspondingly, bond yields should rise at a measured pace.

  • As the labor market in the euro area is improving, moderate acceleration in labor costs can be expected. As a result, the EMU core inflation could rise to approximately 1.5% in the next one to two years. Strong domestically driven inflation, however, seems quite unlikely.
  • Despite the currently synchronous economic expansion in the US and in the euro area, the inflation risks are still different. In the US, in view of low unemployment and a strongly pro-cyclical fiscal policy, there are certainly risks of economic overheating and thus also inflation risks. In the euro area, the inflation target of just under 2% is coming closer, but has not yet been met.

  • In the US, wage growth in the recent past has proved less responsive to labor market conditions than in former decades . Nevertheless, the inverse link between unemployment rate and wage growth is not out of force . Overall, the core CPI inflation rate is expected to move towards 2 ¼ -2 ½ % in 2019.

  • A stronger acceleration of inflation on both sides of the Atlantic could be triggered by a surge in oil prices. We have calculated the effects of an increase in the oil price per barrel (Brent) from currently around USD 65 to around USD 90. In this case, we estimate that consumer prices will rise by 1.8% in the euro area in 2018 (instead of 1.5%) and by 2.5% in 2019 (instead of 1.7%). In the US, rising energy prices would increase annual average inflation by 0.4 percentage points in both the current and the coming year.

  • Barring a sudden spike in oil prices, the inflation outlook suggests a moderate and gradual rise of long-term bond yields. 1.5% in Germany and 3.5% in the US seem plausible forecasts for 10-year government bond yields at the end of 2019. In the case of abruptly rising energy prices, the US Federal Reserve should raise the key interest rate next year by an additional 50-75 basis points. The effect of these additional key interest rate steps on long-term interest rates is somewhat less, so that the yield curve would flatten sharply. The ECB would likely respond prudently to an oil price-related price surge and weigh the risks of inflation-increasing second-round effects against the inflation dampening effects of lower aggregate demand.

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