Taking the current implied path of oil prices (rising from the current level of $50 per barrel (p/b) to $56 p/b in December 2017) and assuming a steady euro versus the US dollar, then oil prices in euros should be up 55% in February 2017. This roughly translates to 10.5% energy inflation – not seen since the previous spike in oil prices in 2010.
All else held equal, Eurozone inflation will return back up to near 2%, before falling back down.
Of course, oil prices could move higher or lower in the coming year. There are two alternative scenarios; where the y/y path of Brent would be if the level was to move to $30 and $70 per barrel by the end of 2017. With the weaker scenario, oil peaks at 30% y/y in February, whereas in the $70 p/b scenario, oil peaks at 64% y/y.
In all three scenarios, energy inflation comes back down from the February peak by the end of 2017. However, the scenario implied from oil futures has fairly neutral energy inflation, compared to a significant positive contribution in the $70 p/b case, and a very negative impact in the $30 p/b scenario.
Looking only at the baseline (oil futures) scenario, if we assume all else is held constant (core plus food including alcohol and tobacco) then the rise in energy inflation will cause the headline rate of Eurozone inflation to rise to about 1.9% by the end of the first quarter of 2017 (chart 6). However, the impact from energy then fades, suggesting a fall in the headline rate back below 1%.
In reality, core and food price inflation are unlikely to remain constant. Core inflation is likely to rise as a significant proportion of prices are administered, and contain an element of price indexation. Therefore, as headline inflation rises in the coming months, core inflation is likely to follow about six months later.
Fall in sterling to exacerbate the rise in UK inflation
Like the Eurozone, the UK is facing similar price dynamics from energy; however, the rise in inflation is likely to be exacerbated by the fall in sterling following the UK’s decision to leave the European Union.
Oil prices adjusted for sterling versus UK energy inflation. Again, we have taken the implied path of oil prices from forward curves, and looked at the same upside and downside scenarios. The stark difference between the UK and Eurozone profile is the height of the spike up in prices – 95% in early 2017 compared to 55% for the Eurozone in the baseline.
We assume sterling falls to 1.20 versus the US dollar by the end of 2017, and the above chart shows a mechanical calculation. In reality, the currency impact can take a little longer, as we saw in 2007 and again in 2009.
Sterling has fallen 18.4% in trade-weighted terms y/y, but 21% y/y against the US dollar, which is key given most commodities are priced in the greenback. The fall in the pound will not only raise energy prices, but also food prices and import prices for goods more generally. About a third of the
consumer price index is made up of imported goods, so as a rule of thumb, the pass-through from currency devaluation tends to be about a third, but over two to three years. The official food price index versus the UN global food price index, adjusted for sterling and with a six month lead suggests that food price inflation is set to return to being positive, potentially rising to over 6%
y/y, or to 2011 highs.
The Office for National Statistics’ (ONS) inflation release for September showed a jump in CPI inflation to 1% y/y, up from 0.4% y/y in August, and the fastest rate of inflation since November 2014. The energy base effects have started to drop out, but the ONS reported very little sign yet that sterling had started to feed through into CPI.
Taking the above analysis on the energy index and the broader impact from the fall in sterling, we forecast UK CPI inflation to rise to above 3% y/y by the middle of next year (chart 9). CPI inflation is expected to average 2.9% over 2017. This is an interim estimate from our quarterly forecast which will be revised in next month’s publication.