From inflation risk to deflation risk
The strong process of slowdown in price growth, which has led to widespread concern about the effects of a possible deflation on the economy, has been going on for over two years now. Although common to the entire euro area, this phenomenon is more intense in Italy than in Germany and France.
In Italy, from inflation close to 4% in the first part of 2012, price growth turned negative in August (-0,2%). In Germany, the reduction in inflation stopped at 0,8%, from the 2,9% that had been reached in October 2011, while in France it fell slightly lower (from 2,7% in December 2011 to 0,6% in July, latest data available). In two and a half years, French and German inflation fell by 2,1 percentage points, while the Italian one by 4.
In addition to the greater extent of the decline, the Italian inflationary context has been characterized by profound volatility since the outbreak of the crisis. Until 2006, substantial stability led to inflation hovering just above the European Central Bank's target of 2%. From the second half of 2007 a phase of strong fluctuations began. In the first months of the crisis there was a rapid acceleration which brought inflation from values below 2% to over 4%, the highest level in the last eighteen years. After a sharp fall, with inflation measured by the harmonized index falling into negative territory for the first time in mid-2009, price growth accelerated again, approaching 4% in the first part of 2012, before starting this new slowdown phase. This variability finds a part of the explanation in the rapid swings that have affected the energy. The growth in prices of this component first exceeded 15% on an annual basis in the second half of 2008, to then collapse with declines close to 15% in mid-2009, to then accelerate again with increases still exceeding 15% in the first part of 2012 and finally begin this new phase of decline, with decreases of around 3%.
A widespread decline among the various expenditure items
Already in 2009 Italy had experienced a sharp slowdown in price growth, with inflation in negative territory. However, the current phase presents some particularities compared to what happened in the first part of the crisis. The slowdown in price growth now appears more generalized and widespread, making the drop in inflation worthy of more attention.
In August of this year, the fall in the general index is the result of a decline in the prices of goods, a contraction of 3,7% in those of energy and an increase of 0,3% in those of services. The effect of the energy component appears much less strong than that recorded in 2009, when -0,1% of the general index was accompanied by -14,6% of energy. In August 2014, the decline in energy supplies a negative contribution to the growth of the general index equal to only 0,3%, almost a quarter of what the same component subtracted in July 2009. Even the decline that today affects the prices of goods appears more contained, with a negative contribution equal to less than half that of five years ago. However, unlike in the first part of the crisis, the slowdown in inflation also affects services. In mid-2009, the growth of prices relating to this component remained above 1,5%, while now we are approaching zero.
In August 2014, four of the eleven expenditure items that make up the general index recorded negative inflation. Food prices have fallen by almost 0,5% compared to last year. The sharp decline in fresh products weighed on the decline, with fruit prices dropping by almost 10% in July, the latest data available for individual types of goods and services. Inflation also turned negative in the housing, water, electricity and fuel chapters and in the clothing and footwear chapter. In the first case, the drop in prices is the result of a large drop in gas prices and a slight contraction in rents for homes, while prices for water supply and the collection of waste. The only chapters to record price increases of more than 1% are that of health services and health expenditure and that of education.
A deflation that also comes from abroad
The drop in inflation in Italy finds an important part of the explanation in the drop in import prices. The impact of the weakness of domestic demand, although evident, is less significant for now.
Import prices have been experiencing negative growth for over a year. At the beginning of 2011, inflation referring to products purchased from abroad was over 9%, driven by the energy component, which with prices growing by almost 30% explained more than half of the overall increase. In the following months, imported inflation slowed down and then turned negative. The decline, after approaching 4%, was 72 September 2014 equal to over 2% in May 2014, the latest data available. Several factors help to explain the development of import prices. In the last two years, the evolution of the exchange rate has taken on a certain importance. Between July 2012 and May 2014 there was an appreciation of the euro against the dollar of more than 10%, which made purchases from abroad less expensive. For imported goods and services, negative inflation today affects all the main groupings of industries, being less intense for consumer goods (-0,7%) and for energy (-1,5%), which arrives to explain only a small part of the overall decline. On the other hand, the fall in prices is close to 3% for capital goods and intermediate goods, the latter alone explaining almost half of the fall in the general index. Looking at the individual sectors of economic activity, in May only the sector of textiles and clothing recorded a growth, albeit moderate, in the prices paid to purchase products from abroad. All the other sectors that make up manufacturing, on the other hand, suffered a fall in prices, with declines that exceeded 4% in means of transport and metals. In some sectors, negative imported inflation has now become an almost structural fact. The metals sector, which at the beginning of 2011 recorded import price growth close to 20%, has been in deflation for over two years. The period of negative prices is even longer for pharmaceutical products, with a decline that began in the first part of 2011.
Negative inflation and GDP deflator
Speaking of deflation, it is also necessary to think about the impact that the change in prices has on the performance of GDP in value. For the same quantity, falling prices are accompanied by a fall in current values, making compliance with public finance objectives in terms of deficit/GDP and debt/GDP ratios even more complex.
Before going to look at the numbers, however, a clarification is necessary. To calculate GDP at current prices, the consumer price index is not considered but another indicator, called the deflator. This is not a mere terminological difference, but assumes a practical relevance. To calculate the consumer price index, the prices of all the goods and services that make up the basket are considered, regardless of their origin. All this means that the reduction in the price of a good, whether produced internally or purchased from abroad, determines a push towards a slowdown in general inflation, the intensity of which will depend on the weight that good has within the basket . The situation for the calculation of the deflator is different. A country's GDP is equal to the sum of consumption, public spending, investment and exports. Imports, which do not represent goods or services produced internally and, therefore, must not be included in the calculation of GDP must be subtracted from this value. If it happens that the prices of imports go down, for the same quantity bought from abroad their value will decrease, with a positive effect on the GDP. Therefore, the origin of the single good is not irrelevant for the calculation of the GDP deflator. The trend in import prices is not added to that of other goods or services as happens with inflation, but it is as if it were subtracted. Negative import inflation therefore has a containment effect on consumer inflation but pushes the deflator upwards, with a positive effect on GDP in value terms.
To imagine the effects of deflation on current values, it is therefore not correct to translate the change in consumer prices directly onto GDP. We need to go and see what are the main drivers of lower inflation. The fact that the trend towards deflation is today also the result of a drop in import prices, rather than the sole result of the weakness of domestic demand, therefore takes on particularly important implications.
A look at the numbers helps to understand. In Italy, the slowdown in price growth appears less evident when viewed from the side of the deflator. At the beginning of 2012, the GDP deflator was growing by almost 2% on an annual basis. In the second quarter of 2014, the increase amounted to 0,7%. A drop of just over 1 percentage point, which compares with the 4 lost by inflation. This trend is explained by the different growth in import prices. At the beginning of 2012, consumer prices increased by about 3,5%, with the price index for imports growing by more than 4,5%. The increase in the value of imports was accompanied by a containment of the growth of the GDP deflator, which stopped below 2%, with a negative difference of more than 1,5% compared to consumer inflation. With import prices rising, the effect of the price increase on GDP was much smaller than imaginable looking at inflation alone. In the first quarter of 2012, the GDP in quantity decreased by 1,7% and that in value grew by only 0,1%, while consumer inflation at 3,5% would have led to imagine an increase close to 2% . The growth in import prices then gradually turned negative, amounting to -2,9% in the first quarter of 2014 and -1,6% in the second. All this has led to an increase in the GDP deflator greater than that of the consumer price index. In the first 6 months of this year as a whole, the GDP deflator increased by 0,9%, while consumer price inflation stopped at 0,4%. A positive difference between the growth of the GDP deflator and consumer price inflation equal to 0,5 percentage points represents an element of particular interest when compared with the average value of the last seventeen years equal to -0,1%. The effect of the change in prices on GDP is therefore greater than that imaginable by looking at inflation alone. In the first half of 2014, while the GDP in quantity decreased by 0,3% compared to the same period of the previous year, the GDP in value increased by 0,6%. Consumer inflation of 0,4% would have led to think of a substantial stagnation of the current value.
A look into the past
To complete the discussion, one last aspect deserves to be underlined. As seen above, the price trend in Italy is often different from that of France and Germany. This peculiarity characterizes the current phase of sharp slowdown in prices, but it can also be traced in the previous period, when it was not deflation that worried but the risk that prices could rise too quickly. Between 1996 and 2012, Italy has always experienced a higher price increase than that recorded in the other two main economies of the euro area. In the fifteen years considered, annual inflation in Italy averaged 2,3%, compared with 1,7% in France and 1,6% in Germany. The differential between Italian inflation and that of the other two countries was positive in all the years considered, with the sole exception of 2007 for Germany and 2004 and 2010 for France. Even in the years of the crisis, our country experienced inflation which on average was higher than that of the other two countries, despite a much more intense weakening of domestic demand than in France and Germany. Overall, from 1996 to 2012, the consumer price index increased by 44% in Italy, 16 percentage points more than Germany and 12 more than France. This faster growth in prices is the result of differentiated dynamics at the level of individual types of goods and services, with some aspects of particular interest. The higher inflation did not derive from higher energy costs, but above all from the faster growth in food prices, housing costs and health care costs.
Between 1996 and 2012, energy prices increased by almost 90% overall in Italy, compared to 110% in Germany, while food prices increased by almost 40%, almost 15 percentage points in more than what happened in Germany. A positive contribution to the higher inflation came, for example, from milk, cheese and eggs, but above all from plant products. In sixteen years the price of vegetables and greens has increased by more than 40 percentage points more than recorded in Germany. Among the expenses for housing, which grew by more than 70%, Italian families had to face significant increases in the tariffs for waste collection, which grew by almost 90%, more than 50 points more than Germany, and for the supply of water, the latter more than doubled. Of the various chapters that make up the basket for calculating inflation, education is the only one in which Italy recorded a more moderate price trend compared to both France and Germany.
A reflection to conclude
All these numbers tell us how complex the phenomenon of inflation is. Some aspects deserve to be highlighted.
Today there is above all concern about the negative effects that a possible deflation could have on economic growth. However, what is happening in Spain tells us that reality can also be very different from theory. In Spain, prices are falling, inflation was -0,5% in August, but the economy is growing, driven by consumption which, according to some observers, is boosted by a recovery in the purchasing power of income favored precisely from the fall in prices. There is also concern about the effect that declining inflation can have on compliance with public budget constraints. The numbers for Italy tell us, however, that to understand what is really happening it is not enough to analyze general inflation, but it is necessary to look inside. Declining import prices make the impact on nominal GDP growth less serious than it would appear at first glance. Furthermore, reading the inflation data is useful for underlining some critical issues that characterize our country, as well as for describe some changes that interest us as a result of seven years of crisis. Comparing the present with the past, an aspect of particular interest emerges: today, which is concerned about deflation, Italian prices are falling more rapidly than those in France and Germany; yesterday, when inflation was the concern, our prices were growing faster. This must lead us to think that, perhaps, in our country, something is not working correctly in the price formation process. What happens to the price index relating to the clothing and footwear sector appears to be very interesting. The drop in prices is affecting fabrics, garments, accessories and footwear. The only prices to increase are those of laundry, repair and clothing rental services. These dynamics go beyond the clothing and footwear chapter: prices for the repair of household appliances grow by almost 102% and those for the repair of furniture, fittings and means of transport by about 2014%. Although this is only the beginning of a process, these data could be representative of a change in consumer habits, with a greater focus on the repair services of the available goods at the expense of the purchase of new products. The prices of the former can, therefore, continue to grow, while companies that sell new products are called to be more cautious in pricing, to try to counteract the weakness in demand.
