Fall in Commodity Prices

The sharp fall in oil prices, with Brent crude down 60% since the June 2014 peak, while certainly providing a powerful boost to global consumption, creates further challenges to several central banks in advanced economies trying to lift inflation from very low levels.

In order to provide an analytical framework to assess vulnerabilities to global disinflationary impulses we utilise our deflation risk index, which ranks deflation risks based on a threshold system1. This allows us to capture when economic activity, price pressures, spare capacity, credit and monetary dynamics are at critical levels. We are therefore in a position to distinguish countries where external disinflationary effects are likely to prove temporary and where on the other hand there are severe risks that low inflation becomes embedded in longer term inflation expectations, hence requiring a greater policy response.

As highlighted in Chart 1, European countries face the most significant risks, with the Eurozone clearly standing out in terms of vulnerability to the recent global disinflationary bout. This is due to a negative mix of already-low inflation, an open output gap, with the high unemployment rate (now at 11.5%) suggesting a large degree of spare capacity, and very subdued credit dynamics. Furthermore, Chart 2 suggests that while most major economies have made significant progress since the onset of the great financial crisis in addressing the low-inflation problem, the Eurozone has lagged behind and deflationary risks in the single currency area have mounted such that they seem to be now higher than in 2009.

Perhaps surprisingly, despite the strong cyclical story, the UK ranks also on the vulnerable side, mostly on the back of risks associated to broad monetary dynamics, with past GBP appreciation filtering through and still a very poor credit axis. Furthermore the lowest unit labour cost growth among advanced economies adds to vulnerabilities. These dynamics became evident in the latest inflation releases with inflation moderating to only 0.5% YoY. We view these vulnerabilities as the main near-term hurdle for markets to re-price the potential of BoE tightening in H2 2015, hence keeping GBP appreciation potential in check.

North America on the other hand is positioned on the other side of the spectrum, with Canada and the US being better placed to look through the fall in commodity prices from an inflation perspective. In the US, solid growth dynamics, inflation closer to target and a banking sector in a better shape to accommodate rather than act as a drag on the economic expansion suggest greater potential to generate domestic inflation. While Canada shares in many respects a similar position, the economy’s exposure to the oil sector (oil makes up about 15% of total exports), creates greater uncertainty on second-round effects following the fall in terms of trade (e.g. negative spillovers on the banking sector, housing market etc..), which was partly behind BoC’s surprise “precautionary” rate cut on January 21st.

Staying in the commodity complex, very easy monetary conditions, solid credit growth, a small output gap and at-target inflation suggest disinflationary forces will have a very negligible impact in Norway. This could at some point be a source of support for NOK when commodity markets stabilise. Uncertainty on the near-term macro outlook is clearly high though given the sharp fall in oil prices.

The clearest implication from this analysis is that while some countries, notably the US, are in a position to look through the current disinflationary forces acting on a global scale, others, the Eurozone in particular, are at greater risk of more permanent effects on the medium-term inflation outlook and of a more marked de-anchoring of inflation expectations. The recent oil price shock therefore deepens an already emerging monetary policy differentiation between the two sides of the Atlantic, with the ECB acting behind the curve and significant heavy lifting left to do.

1The deflation index is based on the methodology adopted by Decressin and Laxton in the IMF paper “Gauging risks for deflation”, 28 Jan 2009.

Chart 1. Deflation risk index: European countries more exposed, led by the Euro zone 

Deflation risk index: European countries more exposed, led by the Euro zone

Source: Haver, OECD, Bloomberg, Millennium, as of January 20th, 2015

Chart 2. Eurozone clear laggard in the fight against low inflation 

Eurozone clear laggard in the fight against low inflation

Source: Haver, OECD, Bloomberg, Millennium, as of January 20th, 2015

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