ECB watching oil and euro closely for inflation risks

Eurozone deflation has become less likely since the beginning of 2015, but falling oil prices could threaten the economic outlook, according to the governing council of the European Central Bank (ECB).

Members of the council agreed the low oil price and euro exchange rate meant there were "downside risks to the September 2015 ECB staff projections for inflation", according to the "account" of its September 2–3 meeting, published today (October 8).

Falling energy prices and other sources of international economic volatility also increase the difficulty of modelling the inflation outlook, the council agreed.

Compared with the situation at the start of 2015 the risk of "broad-based deflation pressures" was "low and had decreased", the council agreed. Most modelling of future eurozone inflation and growth, however, now predicted "further downward revisions".

While the deteriorating inflation outlook was driven largely by energy prices and "to some extent" by the euro exchange rate, the "risk of second-round effects needed to be monitored closely in the period ahead", the account added.

There were "exceptional" changes to some assumptions underpinning the staff modelling of future inflation, the board noted. The "high sensitivity" of modelled predictions to the assumptions used, "in particular the oil price", meant the council "should be cautious in extrapolating from recent developments and not place too much weight on the latest data".

In a context of "such high short-term volatility" the account notes "every update of the assumptions provided only a temporary snapshot of the economic environment". It was unwise to "draw premature conclusions from any short-term developments, which might vary from one day to the next".

In contrast with oil prices, estimates of domestic price pressures, including measures of underlying inflation, were "rising over the projection horizon" and had "largely developed in line with earlier expectations", the council noted.

In a sign of possible problems moving forwards, council members noted the increase in market-based measures of inflation expectations had stalled somewhat.

The council noted there was a correlation between oil prices and inflation expectations, adding "in the past year-and-a-half, the link between current inflation and inflation expectations appeared to have strengthened considerably".