Situación

Españ

Global disinflation in

an era of

constrained

monetary policy

Comments to

Madrid, October 24th

2016

Rafael Doménech

Bank of Spain

Global disinflation in an era of

constrained monetary policy

Global disinflation: main IMF’s messages

Inflation has declined substantially in a large number of countries as a result of

persistent labor market slack and weaker import price growth (cross-border spillovers)

Phillips curve residuals have tended to become larger: a sign that price setters’ inflation

expectations have declined more than survey-based measures?

Inflation expectations in advanced countries with constrained monetary policy are more

sensitive to unexpected changes in actual inflation or commodity prices

Most likely scenario: a recovery of inflation toward central banks targets as slack

diminishes and declines in commodity prices fades, but with risks of a downward drift in

inflation expectations

These results calls for a comprehensive and coordinated effort to tackle the risks of low

inflation maintaining monetary accommodation, and implementing policies to

boosting demand and reducing overcapacity

2

Global disinflation in an era of

constrained monetary policy

Structure

1. disinflation evidence for EMU and the Spanish economy

2. Causes and effects of a low inflation scenario

3. Inflation outlook and policy challenges

3

Global disinflation in an era of

constrained monetary policy

EMU: BBVA Inflation Monitor Index

A low inflation scenario: EZ Inflation Monitor Index

Source: Bloomberg and BBVA Research (2015), https://goo.gl/t6gVvN

The principal component of the

following variables at monthly

frequency:

4

Current

2y

5y+

• Headline inflation

• Core inflation

• GDP deflator

• ECB’s inflation forecasts 2y

• Two-year inflation swap

• Survey Professional Forecasters

• Five-year inflation swap

• Long-term inflation swap by SPF

• 5y5y forward inflation swap

-6

-5

-4

-3

-2

-1

0

1

2

3

4

Ja

n-0

9

Ja

n-1

0

Ja

n-1

1

Ja

n-1

2

Ja

n-1

3

Ja

n-1

4

Ja

n-1

5

Ja

n-1

6

short term medium term long term

Whatever it

takes

Forward

guidance

TLTROsCBPP3 ABSPP

QE

Jackson Hole

meeting

1. Evidence

Global disinflation in an era of

constrained monetary policy

Spain and EMU: trend inflation

(% YoY, Trimmed mean method)

A low inflation scenario: trimmed mean inflation

Source: BBVA Research based on INE and Eurostat. See Box 1 “The moderation of Spanish inflation over the last five years”, Spain Economic Outlook, 1st quarter, 2014,

https://goo.gl/goh0kk 5

Trimmed mean inflation

• This method utilizes the empirical distribution

of CPI components

• The mean μα,β trims α% of extreme values in

the left tail of the CPI distribution and β% in

the right tail

• The criterion we applied to select the optimum

trimmed-mean was its predictive capacity

with respect to annualized mean inflation over

a forecast horizon of 30 months

-1,0

-0,5

0,0

0,5

1,0

1,5

2,0

se

p-1

0

se

p-1

1

se

p-1

2

se

p-1

3

sep-1

4

se

p-1

5

se

p-1

6

Spain EMU

1. Evidence

Global disinflation in an era of

constrained monetary policy

Structure

1. disinflation evidence for EMU and the Spanish economy

2. Causes and effects of a low inflation scenario

3. Inflation outlook and policy challenges

6

Global disinflation in an era of

constrained monetary policy

Should we be worried about a low inflation scenario?

7

Main concerns about a low inflation scenario:

• When low inflation is caused by negative demand shocks vs positive supply shocks

• More difficult deleveraging process and wage and relative prices adjustments

• Risk of de-anchoring inflation expectations

• In combination with low real equilibrium interest rates it increases the probability of

reaching the effective lower bound (ELB), making conventional policies less effective

What is behind low inflation in EMU?

1. Labor market slack: lower inflation in countries with higher unmeployment rates

2. Low commodities prices (e.g., oil prices) are good for EMU countries and facilitate

the deleveraging process (Spain, as an example)

3. Inflation expectations are slightly procyclical, particularly in the case of financial

market-based variables

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

Aggregate unemployment rate in EMU

(%)

1. Inflation and unemployment

Source: BBVA Research based on Haver and the Area-wide Model for the EA

https://goo.gl/pb7JfJ 8

Inflation and unemployment in EMU

countries at the end of 2014 (%)

Source: BBVA Research based on Eurostat

6

7

8

9

10

11

12

13

1Q90 1Q93 1Q96 1Q99 1Q02 1Q05 1Q08 1Q11 1Q14 1Q17

9.7%

AT

DE

LU

FI

EE

BE

SI

MT

NL

FR IT

LT

IE PT

SK

ES

EL

CY

EMU (EQ)

-1.2

-0.7

-0.2

0.3

0.8

1.3

1.8

4 8 12 16 20 24 28

Core

in

flation

, D

ece

mb

er

20

14

, y/y

(%

)

Unemployment rate, November 2014 (%)

EMU

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

Spain: percentage change in prices (Average percentage variation YoY)

2. Import prices and recovery

Source: BBVA Research and INE. Consumer prices are from the variation in the

Consumer Price Index. Output prices are from the GDP deflator 9

Saving

continues to

rise due to the

drop in

imported

goods prices…

…and the rise

for those

produced

domestically…

… which means

that margins are

increasing, but

without affecting

productivity

EMU output

prices 1.1

Consumer

prices

Output

prices

0.1

0,5

-0.4

2010-14

2015

2010-14

2015

1.7

0.6

-0.4

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

Spain: saving, investment and net lending capacity % of GDP

2. Import prices and recovery: the “divine coincidence”

Source: BBVA Research based on Bank of Spain. See BBVA Research (2015) 10

Saving

Investment

Net borrowing needs

Net lending capacity

25

24

23

22

21

20

19

18

17

16

15

Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Jun 15

Virtuous “trinity”

of growth, low

inflation and

deleveraging in

relation to the rest

of the world

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

3. Inflation expectations

Source: BBVA Research

As recognized by the IMF, it is not a surprise

to observe differences in survey- and

market-based measures of inflation

expectations

SPF long-term inflation expectations are

rather stable

Market-based expectations are more volatile

and deviate persistently from central banks’

targets, due to inflation surprises and the

perception of a less effective monetary

policy

In EMU, the Phillips curve yields better

estimates with SPF long-term inflation

expectations than with 5Y5Y forward inflation

swap 11

HICP and inflation expectations in EMU (y-o-y, %)

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

1Q

05

2Q

06

3Q

07

4Q

08

1Q

10

2Q

11

3Q

12

4Q

13

1Q

15

2Q

16

SPF 5Y5Y swap HICP

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

Explaining recent inflation dynamics

Source: BBVA Research 12

EMU: contributions to inflation (y-o-y, %)

-0.02

-0.01

0

0.01

0.02

0.03

0.04

1Q

97

1Q

98

1Q

99

1Q

00

1Q

01

1Q

02

1Q

03

1Q

04

1Q

05

1Q

06

1Q

07

1Q

08

1Q

09

1Q

10

1Q

11

1Q

12

1Q

13

1Q

14

1Q

15

1Q

16

1Q

17

Imports Uc Inf(e) Inf(-1) HICP

EMU: Phillips curve estimates (1Q1997-3Q2016)

• 2009: fall of import prices

• 2013-16: more persistent fall of import prices

and cyclical unemployment rate

• Lagged inflation is important

• The negative contribution of import prices is

expected to disappear in 2Q2017

• There is no evidence that residuals are larger

but they were positive in the sovereign debt

crisis and negative when financial conditions

improve, a result in line with Gilchrist et al, 2013

2. Causes and effects

Global disinflation in an era of

constrained monetary policy

Structure

1. disinflation evidence for EMU and the Spanish economy

2. Causes and effects of a low inflation scenario

3. Inflation outlook and policy challenges

13

Global disinflation in an era of

constrained monetary policy

EMU: HICP forecasts (%)

Forecasts for headline and core inflation in EMU

Source: BBVA Research 14

EMU: core inflation forecasts (%)

Source: BBVA Research

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Ja

n-0

4

Ju

l-0

5

Ja

n-0

7

Ju

l-0

8

Ja

n-1

0

Ju

l-1

1

Ja

n-1

3

Ju

l-1

4

Ja

n-1

6

Ju

l-1

7

20% 40% 60% 80%

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Ja

n-0

4

Ju

l-0

5

Ja

n-0

7

Ju

l-0

8

Ja

n-1

0

Ju

l-1

1

Ja

n-1

3

Ju

l-1

4

Ja

n-1

6

Ju

l-1

7

20% 40% 60% 80%

3. Inflation outlook and policy challenges

Global disinflation in an era of

constrained monetary policy

Inflation forecasts and policy challenges

15

Monetary policy challenges: instruments, effectiveness and credibility

• Base scenario: allow the inflation to be higher than objective for some time, if

needed. Long-run challenges of low r* (Lansing, 2016, Neut and García, 2016)

• Higher inflation scenario: QE exit strategy and forward guidance to avoid excessive

volatility in financial markets (Bernanke, 2015, and Taylor, 2015)

• Lower inflation scenario: additional measures, interaction w/fiscal policy (Sims, 2016)

Fiscal policy challenges

• Base scenario: continue with fiscal consolidation and long-run fiscal union process

• Higher inflation scenario: no plan B in countries with high levels of public debt

• Lower inflation scenario: fiscal policy at EU level (ESBies, Brunnermeier et al, 2016)

Base scenario: gradual recovery of inflation toward central bank targets

• EMU: inflation at 1.6% in Dec. 2017 and 30% probability of being greater than 2

3. Inflation outlook and policy challenges

Global disinflation in an era of

constrained monetary policy Título presentación Fecha

Situación

• Españ

Global disinflation in

an era of

constrained

monetary policy

Comments to

Madrid, October 24th

2016

Rafael Doménech

Bank of Spain