Supercore inflation guides ECB as oil muddies price outlook

[FRANKFURT] Carpets, vacuum cleaners and cups of coffee: those are three of the key consumer items that economists at the European Central Bank (ECB) are pondering to figure out whether oil's slump is leading the euro area into deflation.

As the return of negative headline inflation stokes investor expectations for more monetary stimulus, policy makers are looking for ways to strip out the noise and determine whether price weakness is becoming ingrained in the economy. If a self-sustaining spiral of falling prices and wages truly beckons, the Frankfurt-based ECB needs to know.

Enter so-called supercore inflation, one of the measures officials use to try to gauge the fundamental trend. While the central bank targets headline inflation, aiming to keep it at just under 2 per cent, and looks at various gauges that remove volatile items, this method tries to go deeper. It tracks a subset of prices that move in tandem with the slack in the economy.

"You can't set monetary policy looking in the rear-view mirror," said Richard Barwell, senior economist at BNP Paribas Investment Partners in London.

"Underlying inflation should tell you where inflation is going, where inflation would be today in the absence of these price-level shocks."

Euro-area inflation was minus 0.2 per cent in February, the sixth time in 15 months that the reading has been negative, European Union figures showed Monday.

Core inflation slowed to 0.7 per cent. That's an 'exclusion measure' removing the elements most liable to swings - in this case food, energy, alcohol and tobacco - and is the simplest way of trying to separate underlying price movements from temporary factors.

'Supercore' - a term the ECB uses internally though not in its published work - is based on about a third of the items in the core inflation basket. Those are closely correlated with the output gap, or the spare capacity in the economy. An ECB article in its Sept 2014 bulletin listed furniture, carpets, household appliances, package holidays and cafe services among the components tracked.

The measure was described as "smoother" than traditional core inflation, making it "easier to gauge turning points" in the consumer price index. The ECB hasn't published an updated version of the gauge since that bulletin.

"It makes sense to look at a number of indicators in order to give a thorough, rounded assessment as to what the underlying inflation trend is, and where inflation is likely to be in the medium-term," said Nick Matthews, co-head of European economic research at Nomura International Plc in London.

"It's increasingly important at this particular juncture, because there's a significant deterioration in inflation expectations as well."

Supercore is just one of the ways the ECB has to gauge underlying inflation. Others, like U2core, try to statistically filter out the persistent component of each price in the inflation basket.

Officials will decide on March 10 whether the euro area needs more monetary stimulus. The multiple indicators mostly show underlying inflation slowing, reinforcing the idea that cheap energy is damping prices.

While that can be positive for spending, as some policy makers have argued, it can also curb wage rises when those increases are linked to current or projected inflation.

"It's a very tough situation to see oil collapsing and leading to another decline in inflation forecasts, for reasons that are not fundamental reasons that the ECB can have an effect on," said Frederik Ducrozet, an economist at Banque Pictet & Cie SA in Geneva.

"Against a slightly weaker economic background, it becomes a bigger risk for the ECB that core inflation also gets dragged down. And that's the difficult situation that the ECB finds itself in."

BLOOMBERG