Commodity Prices and Inflation in Denmark

Transcription

1 79 Commodity Prices and Inflation in Denmark Morten Spange, Economics INTRODUCTION AND SUMMARY One of Danmarks Nationalbank's main objectives is to ensure price stability. In practice, monetary policy is planned with a view to keeping the krone stable against the euro. Danish monetary policy thus reflects the policy of the European Central Bank, ECB, whose main objective is to keep inflation in the euro area below, but close to, 2 per cent a year. The Danish economy is closely integrated with that of the euro area. As a result of Denmark's fixed-exchange-rate policy, monetary policy that ensures low inflation in the euro area will also lead to low inflation in Denmark. And since 990, inflation in Denmark has in fact averaged 2. per cent, measured by the annual rate of increase in the Consumer Price Index, CPI. In the long term, inflation is determined by monetary policy. However, shocks continually hit the economy, causing inflation to fluctuate around its long-term level. In the short to medium term, inflation is, to a large extent, determined by capacity pressures. An increase in demand leads to higher capacity pressure, which is reflected in rising prices. Inflation is also impacted by supply-side factors for example, new technologies could enable a reduction in production costs. Changes in indirect taxes are also reflected in inflation, as are factors originating outside Denmark. An increase in import prices has a knock-on effect on inflation. The same applies if commodity prices rise. Recently, consumer price inflation has been above 2 per cent. According to the Harmonised Index of Consumer Prices, HICP, inflation was 3. per cent in May, cf. Chart. Strong fluctuations in commodity prices cause energy and food prices to fluctuate markedly. Core inflation, which excludes energy and food prices, is more stable, at.7 per cent in May. Two factors stand out in relation to consumer prices in recent years, i.e. higher indirect taxes on energy, tobacco and a number of unhealthy food items, phased in during 200, and price increases on energy and food on the commodity exchanges since early 200. On the See Spange (2009) for a discussion of the link between monetary policy and inflation.

2 80 INFLATION Chart Per cent, year-on-year HICP Core inflation Food Energy Note: The most recent observations are from May 20. Source: Statistics Denmark. other hand, the weakening in private-sector demand since 2008 has had a dampening impact on inflation. In 2009, the Folketing (Danish parliament) adopted the Spring Package 2.0 tax reform, introducing higher taxes on energy, tobacco and unhealthy food from January 200. According to the Ministry of Finance, this increased the tax burden of Danish households by just under kr. 4 billion in 200, equivalent to approximately 0.5 per cent of private consumption. Assuming full pass-through to consumer prices, the Spring Package caused HICP inflation to rise by an estimated 0.5 percentage point in 200. Provided that the tax increases are fully passed through to consumer prices in the month of implementation, their direct impact on annual consumer price inflation lapses after exactly one year. Accordingly, the tax changes that took effect on January 200 no longer impact inflation from January this year onwards, but inflation is still boosted by some further minor tax increases, phased in in July 200. The strong fluctuations in inflation during recent years are driven mainly by commodity prices. If commodity prices go up, this has a direct impact on consumer prices for energy and food. The production costs of firms will also be affected, which may, in turn, filter through to the prices of other goods. A rise in commodity prices provides a lift to prices, but will not, in itself, have any sustained impact on inflation. However, See the Ministry of Finance (2009).

3 8 periods of rising commodity prices entail a risk of a wage-price spiral, which creates a sustained lift to inflation. Experience from the past decade indicates that increases in energy and food prices have only a temporary impact on inflation in Denmark. Overall, the analyses in this article suggest that the relatively high consumer price inflation seen during recent months will be transitory. INFLATION AND COMMODITY PRICES Prices of a number of commodities have been fluctuating greatly in recent years, including food, metal and oil prices, cf. Chart 2. The run-up to the 2008 financial crisis was marked by rising prices, with particularly strong increases for oil and food. In the autumn of 2008, price rises were followed by sharp declines, oil prices plunging to less than one third of their peak levels. Since early 2009, commodity prices have been surging again, and food prices in dollar terms are now exceeding the peak levels of Consumer prices for energy and food are not determined by commodity prices alone. Consumer prices also cover costs and profits related to processing and distribution etc. Moreover, indirect taxes constitute a significant part of the consumer prices of many types of energy. Still, fluctuations in commodity prices are clearly reflected in consumer prices of energy and food, which jointly account for 27.8 per cent of the overall weight basis for HICP. As prices of most other goods and services are relatively stable, fluctuations in energy and food prices explain a significant proportion of the overall variation in inflation during the last decade, cf. Chart 3. Commodities, especially energy, are also a significant input in the production and distribution of a number of products that are not directly related to energy and food. Consequently, increases in commodity prices typically have a broader impact on consumer prices. This was evidenced after the surge in commodity prices in when core inflation, which excludes energy and food, began to rise, cf. Chart 3. When commodity prices dropped in the 2nd half of 2008, core inflation declined, although the effect was lagged. The last year has seen a moderate increase in core inflation, possibly driven by the rise in commodity prices. The slower increase in core inflation at present should be seen in the context of relatively weak private-sector demand, rendering it more difficult for firms to pass on cost increases to consumers. See the article by Niels Peter Hahnemann and Marianne Clausager Koch, International commodity prices: Cycle, bubble or level shift?, p. 6 for an analysis of the factors driving commodity-price developments.

4 82 COMMODITY PRICE INDEX Chart 2 Index, 2000 = Metals Food Oil Note: Prices are in dollar terms. The most recent observations are from May 20. Source: HWWI / Reuters EcoWin. CONTRIBUTIONS TO HICP Chart 3 Per cent Core inflation Energy Food HICP Note: Core inflation is HICP excluding energy and food. The most recent observations are from May 20. Source: Statistics Denmark.

5 83 Using an input-output-based analysis, it is possible to calculate total energy input costs for each krone spent on private consumption. In this way, indirect energy costs related to the manufacture of non-energy products are also included. This may be used to calculate the effect on the overall consumer-price index of an increase in the price of energy input in production. This calculation is based on the assumptions that a change in prices does not lead to a change in the composition of production factors and that factor prices are fully reflected in consumer prices. Furthermore, it has been assumed that indirect taxes are independent of factor prices. An input-output-based analysis indicates that a per cent increase in the factor price of energy input leads to an increase of approximately per cent in consumer prices, cf. Statistics Denmark (20). This masks wide variations across consumer goods. For example, energy-input costs account for slightly more than half of the overall consumer prices of electricity, gas and other fuels and just under one third of the costs of fuels and lubricants for personal transport equipment. So even for these energy-intensive consumption components, a significant proportion of costs is attributable to other production factors (or indirect tax payments). The energy content of other consumption is approximately 2 per cent. Consequently, a per cent increase in energy-input prices may raise consumer prices of non-energy products by 0.02 per cent. The calculations do not take into account that a price increase also leads to higher indirect tax payments, e.g. in the form of VAT. This means that the figures should be seen as a lower limit to how much a commodity-price increase impacts consumer prices, assuming full pass-through. COMMODITY PRICES AND SECOND-ROUND EFFECTS Initially, a rise in commodity-prices increases the overall consumer-price index. However, inflation will not be directly affected in the longer term, provided that commodity prices remain at their new, higher level and do not increase further. All the same, during periods of rising energy and food prices there are often concerns that they might trigger a sustained lift in inflation, e.g. through wage formation. The same principle applies to the calculation of domestic market-determined inflation, IMI, see Hansen and Knudsen (2005). IMI is calculated by subtracting a number of "exogenously" determined prices that do not reflect the development in the domestic market from HICP. As part of this "stripping" of HICP, the indirect energy and import content is also deducted, based on input-output weights.

6 84 Higher prices of selected goods categories inevitably result in an increase in the overall consumer-price index. If it is not evident that inflation will be kept in check in the longer term, employees will believe that the rise in inflation is likely to be a lasting phenomenon. Higher inflationary expectations could increase employee wage demands in collective bargaining. Higher wage increases that are not grounded in correspondingly higher productivity growth will be reflected in higher consumer prices. If employee wage demands soar on the back of higher commodity prices, a wage-price spiral could be created. This was the case in many countries in the 970s when surging oil prices provided a sustained lift to inflation. The term second-round effects is often used to describe a situation in which higher commodity prices produce higher wage demands, inducing a long-term rise in inflation. Statistics Denmark compiles data of consumers' perception of current prices compared with prices 2 months ago and their expectations of price developments for the coming year. Both in 2008 and during the past year, the increase in actual inflation was reflected in the consumers' perception of the current price level, cf. Chart 4. Especially the latest INFLATION EXPECTATIONS ACCORDING TO THE CONSUMER SURVEY Chart 4 Per cent, year-on-year Percentage balance Consumer price inflation, HICP Perception of prices today relative to one year ago (right-hand axis) Price expectations for the coming year (right-hand axis) -60 Note: The percentage balance for households' perception of prices today relative to one year ago is calculated by assigning a weight of 00 to the responses much higher, 50 to the responses somewhat higher, 0 to the responses slightly higher, -50 to the responses unchanged and -00 to the responses slightly lower. The percentage balance for households' price expectations for the coming year is calculated by assigning a weight of 00 to the responses rises at a faster pace than now, 50 to the responses rises at the same pace as now, 0 to the responses rises at a slower pace than now, -50 to the responses remains unchanged and -00 to the responses falls slightly. The most recent observations are from May 20. Source: Statistics Denmark.

7 85 episode of rising inflation has also led to a marked increase in the indicator of household price expectations for the coming year. We have conducted a simple empirical analysis to show the extent to which higher energy and food prices in Denmark are reflected in a sustained increase in overall consumer price inflation. Initially, an increase in energy and food prices causes consumer price inflation to rise, while core inflation remains unchanged, given that it is stripped of energy and food. After one year, the initial (one-off) increases in energy and food prices will have no direct impact on annual consumer price inflation, which will equal core inflation. Moreover, if core inflation is not affected, HICP inflation will revert to its previous level after about one year. If commodity-price increases still affect HICP inflation after one year, it must be because they raise core inflation through their impact on the prices of other goods. This impact may be related to higher wage demands driven by higher inflation expectations (second-round effects) or to higher production costs which are passed on to consumer prices with a time lag. If core inflation increases in response to higher production costs that do not affect wage formation, the impact will be temporary. But if energy and food price inflation is incorporated into the economic system through second-round effects, this will provide a sustained lift to core inflation. The objective of the empirical analysis in Box is to investigate whether consumer price inflation reverts to the initial level of core inflation after a period of high commodity-price increases or whether core inflation begins to rise. On the basis of experience from the last decade, we find that increases in energy and food prices mainly have a temporary impact on consumer price inflation. After one year, consumer price inflation has more or less reverted to the initial level of core inflation, provided that energy and food prices have not increased further. There are also indications, however, that core inflation is, to some extent, positively impacted by higher energy and food prices. The reason may be that higher energy prices cause firms' costs of production to rise, which can be expected to be passed on to consumer prices with a time lag. Furthermore, it may reflect that higher energy and food prices lead to higher wage growth. Based on this analysis, it cannot be determined which of these explanations is the more important. We assume that, after the initial extraordinary one-off increase, commodity prices evolve roughly in line with other prices.

8 86 MODELS OF INFLATION DYNAMICS Box If higher energy and food prices do not create a general increase in inflation, annual consumer price inflation will revert to its previous level after one year. If the increases continue to affect HICP inflation, this is through their impact on the prices of other goods. To investigate whether this has been the case during the last decade, we estimate the equation below on monthly Danish data for the period January 2000 January 20: HICP t HICP core HICP t 2 ( t 2 t 2 ) t core and t are HICP and annual core inflation at time t. t is an error term, and HICP t and are coefficients. A value of 0 indicates that consumer price inflation does not tend towards the initial level of core inflation at all, while a value of means that consumer price inflation is fully adjusted towards one-year lagged core inflation. 2 We get an estimate for of.2, which according to a statistical test is not significantly different from. So there are indications that, after one year, consumer price inflation reverts to the initial level of core inflation. Consequently, an increase in energy and food prices does not result in a significant sustained increase in inflation. We also consider a specification in which the change in core inflation is regressed on the lagged difference between core inflation and consumer price inflation: core t core HICP core t 2 ( t 2 t 2) Here a positive value of indicates that core inflation is affected by a preceding increase in consumer price inflation. This may be interpreted as an indication that second-round effects of higher commodity prices lead to an increase in inflation expectations and, ultimately, to strengthening of the underlying inflation trend. Moreover, core inflation has not been stripped of the indirect energy content. As passthrough from commodity prices to consumer prices is typically lagged, this may cause core inflation to be above its initial level after 2 months. The estimation of monthly Danish data for the period January 2000 to January 20 results in a point estimate for of This estimate is significantly different from both 0 and. So an increase in energy and food prices will produce a rise in the prices of other consumer goods. The period around 2008 stands out as energy prices surged, only to fall back quickly. This period was marked by a sharp cyclical reversal, which may have contributed to ensuring that inflation developments did not lead to higher wage demands. Therefore we have performed a robustness check of the analysis in which the period after December 2007 is excluded. This does not significantly affect the estimation results. t 2 The models comply with Cecchetti and Moessner (2008) and are estimated using autoregressive least squares. The latter is conditional on α = 0, which cannot be rejected by a statistical test. CONCLUSION Overall, the findings of this article indicate that an increase in inflation driven by higher energy and food prices tends to be of short duration

9 87 and that, accordingly, there are no signs of significant second-round effects. In the current situation, consumer price inflation is 3. per cent yearon-year, while core inflation is.7 per cent year-on-year. So the relatively high rate of consumer price inflation is attributable to higher energy and food prices and, based on the findings of the article, must be expected to decline within a short time frame. Moreover, there is currently spare capacity in the Danish economy, cf. Box 3, p. 33, which weakens domestic price and wage pressures. Therefore, the most likely outcome is that inflation will decline within the coming year, cf. the forecast for the Danish economy 20-3, p. 4. It should be noted that households' inflation expectations for the coming year have reached the high level of 2008, when commodity-price increases caused annual consumer price inflation to reach 4.8 per cent. It is a cause for concern if higher inflation expectations are reflected in higher wage demands. However, wage growth is low at present and current capacity pressures do not suggest that it will rise to a level that is incompatible with price stability. Against this backdrop, our assessment is that there is limited risk that the rise in energy and food prices will provide a sustained lift to inflation. This assessment is in line with the ECB's assessment of the conditions in the euro area. Nevertheless, central banks continue to monitor closely whether there are indications of second-round effects of the commodity-price rises and the ECB has emphasised its commitment to use interest-rate increases to consistently counter such trends. See ECB (20).

10 88 LITERATURE Cecchetti, Stephen G. and Richhild Moessner (2008), Commodity prices and inflation dynamics, BIS Quarterly Review, December. Statistics Denmark (20), Danish input-output tables and analysis ECB (20), Interview with Jean-Claude Trichet, President of the ECB, conducted on 20 April 20 by Mr Jorma Pöysä (Kauppalehti) and Mr Juhana Rossi (Helsingin Sanomat), 26 April. Ministry of Finance (2009), Aftale mellem regeringen og Dansk Folkeparti om forårspakke 2.0 (Agreement between the Danish government and the Danish People's Party on Spring Package 2.0 in Danish only), Schultz Grafisk A/S. Hansen, Bo William and Dan Knudsen (2005), Domestic market-determined inflation, Danmarks Nationalbank, Monetary Review, 4th Quarter. Spange, Morten (2009), Price stability and employment, Danmarks Nationalbank, Monetary Review, 4th Quarter.