MARKET MOVER - BNP PARIBAS - Investment Services India

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Eurozone Inflation: Introducing the CLIIP • Consumer price inflation is determined by a mix of demand-pull and cost-push factors, as well as broader financial and monetary conditions. Chart 1: Eurozone Core and Headline Inflation • We have created a Composite Leading Indicator of Inflationary Pressure (CLIIP) for the eurozone, designed to provide an indication of the outlook for core inflation in the months ahead. • Our indicator suggests that disinflationary pressure will dominate in the coming months. A composite leading indicator can be a useful tool when gauging the likely future direction of an economic variable of interest. We have created a Composite Leading Indicator of Inflationary Pressure (CLIIP), which standardises and combines a selection of the numerous influences on inflation into a single data series, providing a summary measure of underlying inflationary pressure. Choosing a reference indicator Any leading indicator needs a reference indicator – a series the leading indicator aims to predict and against which its performance can be assessed. Measures of underlying consumer prices, such as the core HICP, attempt to strip out the most common temporary disturbances to prices by excluding consumer energy and food prices from the index. For this reason, HICP core inflation tends to be more stable than the headline measure and allows for examination of the underlying trends in pricing behaviour. For this reason, we have chosen to make it our reference indicator. Chart 1 shows the behaviour of core and headline inflation over the past 15 years and demonstrates core’s relative stability. By the core HICP measure, underlying inflation in the eurozone has averaged 1.5% y/y since 1997. Our composite leading indicator We have drawn on OECD methodology in creating our indicator 1 . The 10 time series we have selected have predictive power for consumer price inflation and can be categorised as indicators of cost-push pressure on prices, of demand-pull price pressure and indicators of financial conditions. Unless otherwise stated, all relate to the eurozone. Source: Reuters EcoWin Pro The cost-push components The components we include to capture supply-side price pressures include both surveys and hard data. We include the manufacturers’ selling-price survey conducted as part of the European Commission’s monthly business and consumer survey and the Markit input price PMI as two forward-looking measures of pipeline price pressures. Unit labour costs are included as a measure of domestic input price pressure, labour being an input to production. The PPI is included to capture factory-gate prices. A weaker euro increases the cost of imports to euro countries, so we include the ECB’s EER-40 real effective exchange rate (inverted) to capture imported inflation. Demand-pull components To measure the extent to which consumer and company demand are exerting upward pressure on prices, we include eurozone industrial production as a proxy for economic activity. To capture the strength of global demand, we include world trade volumes. To gauge the strength of domestic consumer demand, we use unemployment (inverted) and the DG ECFIN consumer financial conditions survey, which indicates consumers’ optimism about their income prospects. Financial component We include the BNPP Financial and Monetary Conditions Indicator (FMCI) as a broad measure of the tightness of financial conditions in the eurozone. The FMCI is inverted for inclusion in the CLIIP, as tighter monetary conditions are inflation negative. 1 http://www.oecd.org/dataoecd/37/42/42495745.pdf Catherine Colebrook 20 September 2012 Market Mover 4 www.GlobalMarkets.bnpparibas.com
The methodology All of the above indicators can be expected to impact consumer price inflation with varying lags. For example, monetary conditions can be expected to affect prices with a lag of 1-2 years, according to ECB analysis 2 . Shocks to producer prices tend to be passed through more quickly, within 6-8 months. Furthermore, these relationships are not static over time; in general, the lags look to have shortened since the early 2000s. 3.0 2.5 2.0 1.5 1.0 Chart 2: Core HICP and the CLIIP Core HICP (%y/y) We chose the optimal lag to apply to each of the variables according to our view of the current speed of transmission, using correlation coefficients as a guide. To prepare the series for aggregation, we remove any seasonality or trends, invert where appropriate, smooth the series using a Hodrick-Prescott filter, and normalise them (ie. such that they all have mean 0 and standard deviation 1). The series are all given equal weight in the aggregation. The final stage is to transform the index such that it has a mean and standard deviation equal to core inflation, so that the index corresponds to an implied level of annual core inflation. The final CLIIP index is plotted against core inflation in Chart 2. Over the sample from January 2003 to present, the CLIIP has a correlation coefficient with core inflation of 0.67. Between January 2009 and May 2012, the coefficient rises to 0.84. The components with the quickest transmission to core inflation are the consumer financial conditions survey and unemployment, both of which are incorporated into the index with a lag of six months. The index thus gives us a leading indicator for inflationary pressure that extends six months into the future. What does it tell us about inflation? Table 1 lists the components of the leading indicator for core inflation, their level at the last available CLIIP data point (which corresponds to expected inflation in January 2013) and whether each is positive, negative, or neutral for inflation on that horizon. The components are listed in normalised form, meaning that a value above zero implies a positive impact on core inflation; a negative number means a negative impact. As we might expect given that the eurozone economy is currently operating below potential, components indicative of economic slack and a subdued labour market are all inflation-negative: the level of unemployment, consumer expectations, and unit labour costs are all at levels consistent with disinflationary pressure. 2 http://www.ecb.europa.eu/pub/pdf/other/mb201005en_pp85-98en.pdf 0.5 0.0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Source: Reuters EcoWin Pro Chart 3: Unemployment and IP CLIIP Components 3 2 1 0 -1 -2 -3 -4 Unemployment (6-m lag) -0.4 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Source: Reuters EcoWin Pro, BNP Paribas Core HICP (% y/y, RHS) Financial and monetary conditions are also inflationnegative; given that the monetary policy transmission mechanism is still impaired, several years after the credit crunch, this is not surprising either. Recent large falls in the euro can be expected to push up import prices and, therefore, domestic inflation in the eurozone in the coming months, although at 0.2 – less than one standard deviation away from its the long-run average – the normalised level of the REER component suggests the effect will 3 All component data are normalised, while the CLIIP itself corresponds to a level of annual core inflation CLIIP Industrial Production (12-m lag) Table 1: CLIIP Component Breakdown Component Jan 2013 Value 3 2.6 2.1 1.6 1.1 0.6 0.1 Implication for Inflation Consumer financial conditions survey -1.8 Negative Unemployment rate -1.7 Negative BNPP FMCI -0.8 Negative Unit labour costs -0.8 Negative PMI input prices -0.3 Negative Real effective exchange rate 0.2 Positive Manufacturers’ selling price expectations 0.3 Positive Eurozone industrial production 0.4 Positive World trade 0.5 Positive Producer price index 0.6 Positive CLIIP (normalised value) -1.05 Negative Source: BNP Paribas Catherine Colebrook 20 September 2012 Market Mover 5 www.GlobalMarkets.bnpparibas.com
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