The central banks should not overreact to inflation

Economic outlook - 2/8/2017

Inflation has really taken off. However, this comes as no surprise, and the trend is unlikely to last longer than a couple of months. Central banks should therefore not tighten their monetary policy.

US and Euro zone inflation figures rose sharply in December and January:

  • In the United States, the overall rate of inflation, which hit a low of 0.9% in July last year, stood at 2.1% in December, up from 1.7% in November.
  • In the Euro zone, preliminary estimates put the Harmonised Index of Consumer Prices (HICP), which reached a 2016 low of -0.2% in February, at a year-over-year rate of 1.8% in January 2017, up from 1.1% in December and 0.6% in November.

These figures have led to a further rise in long-term inflation expectations, which had already been trending upwards in the second half of 2016 as reflation returned. In the United States, the 10-year inflation swap, which hit a low of 1.52% in February 2016, bounced back to 2.30% at year-end and then 2.35% at 31 January 2017. In the Euro zone, the 10-year inflation swap went from 0.97% in July to 1.47% in December 2016, reaching 1.55% at 31 January (see charts).





However, this uptick in inflation at year-end did not come as a surprise, and we do not think it points to a high level of inflation over the long term. A closer look at the various consumer price index components shows that the increase in energy prices is largely behind this uptrend.

Fluctuations in oil prices create base effects that alter how energy prices impact inflation. When the price of crude oil dropped sharply between mid-2014 and end-2015, the energy component of consumer price indexes put major downward pressure on the overall rate of inflation from the end of 2014 to the summer of 2016. But when oil prices bottomed out in early 2016 and subsequently began to rise again, this downward effect gradually began to ease in mid-2016, and energy prices started pushing inflation back upwards in late 2016 (see charts). 





Core inflation – i.e. inflation excluding volatile components like energy – has remained relatively stable in recent months. In the United States, it stood at 2.2% in December, similar to the average rate for 2016. In the Euro zone as well, core inflation was 0.9% in December and January, in keeping with its 2016 average.

The base effects of the renewed rise in oil prices should continue to push up overall inflation in the United States and the Euro zone over the coming months, but these effects should then gradually disappear, if oil prices level off as we expect them to. If the upswing in inflation since end-2016 is to last, core inflation will have to pick up steam as well, which we do not think will happen.

  • In the United States, we expect inflation excluding energy and food products to be stable, as the upturn in GDP growth should remain moderate in the first half and the rise in the US dollar since August 2016 will keep the lid on imported prices.
  • In the Euro zone, we forecast GDP growth of 1.6% in 2017, after 1.7% in 2016. This will not be enough to fill the output gap, so the rise in core inflation should be modest.





We think that the strong rise in overall inflation will continue in the coming months but will not last over the longer term. Central banks therefore won’t need to react hastily to inflation figures or inflation expectations, and this was confirmed at their recent meetings:

  • At the European Central Bank's (ECB) post-meeting press conference, Mario Draghi defended the ECB’s monetary policy despite the recent rise in Euro zone inflation and argued that there was no “convincing upward trend” in core inflation.
  • The US Federal Reserve, which held its meeting on 1 February, did not change its monetary policy. The tone of the Fed's statement did not change from December. The US central bank expects inflation to reach the 2.0% target in the medium term, indicating that the recent increase in inflation and inflation expectations did not come as a surprise and did not call for firmer action by the Fed.
  • The Bank of Japan (BoJ) and the Bank of England (BoE) also maintained their monetary policies at their respective meetings of 31 January and 2 February. Both banks also released macro reports in which they revised up their growth forecasts in light of the brighter global economic outlook. Neither bank changed their inflation forecast – the BoJ thinks that the economic policies of its partners, particularly the United States, are too uncertain, while the BoE believes that the output gap is wider than it previously thought.



  • Despite the rise in inflation figures, we are maintaining our forecast of two Fed rate hikes this year, in June and December. We expect the ECB and BoJ to continue their quantitative easing programmes throughout the year.
  • The BoE should continue to pay closer attention to the rise in inflation, which has also been spurred on by the sharp decline in the pound. The currency's weakness was triggered by uncertainty surrounding Brexit and by structural imbalances in the UK economy, but the BoE is unlikely to be able to strengthen the pound by raising interest rates. We are therefore maintaining our forecast of no change in the BoE's monetary policy in 2017.