Market Insights

What to Know About Inflation in the Eurozone


Money as a symbol of value moves around the world very quickly, often with the click of a mouse on an online trading platform. In an increasingly global economy with more information and more technology, the ups and downs of the market are not just local phenomena.

Today, it is recognized that when one country has inflation or deflation, it can have an impact on the economy of the rest of the world. With that in mind, there are numerous factors that can cause the market to fluctuate.

Changes in consumer buying habits, the availability of money, political uncertainty, and economic climate are just a few of the factors that can cause the market to fluctuate or boom.

In that regard, the value of currency also reduces over time, so you might notice a drop in prices in everything under inflation. This volatile nature is even more present in the Eurozone, where you can see consumer price inflations skyrocketing at an all-time high.

What is the Euro Area Inflation?

The Euro Area inflation is a reflection of the average price changes of all European countries. On that note, it is also known as the Harmonized Index of Consumer Prices (HICP). This average is a crucial aspect of the economic health of the Eurozone, and basically measures the price changes of the Euro.

As a result of the euro area inflation rate, the interest rates will be affected. This can affect the credit conditions of the domestic companies and policies of the European Central Bank.

What Exactly is an Inflation?

The term inflation refers to a rise in the general price level of goods and services in an economy. It is measured as an annual percentage change in the Consumer Price Index.

The CPI is the most popular and accurate measure of the inflation rate. The annual per cent change in a CPI is calculated by comparing the CPI in a specific month to the same month from the previous year.

Why Did Euro Become the Common Currency for Measuring Inflation?

By the early 1990s, many economists and policy-makers in the European Union (EU) realized that there was a need to move away from the use of individual national currencies. The main catalyst for the introduction of the euro was the instability of some of the European currencies that were being traded at that time.

The solution was to introduce a common currency, the euro, to serve as a benchmark for the countries involved in the EU. The first step in the process began on January 1, 1999. The euro coins and banknotes were introduced by the ECB.

After that, the ECB started making steps to start working on the Euro Area inflation rate, a metric that is based on the average inflation of the 19 euro area countries.

A Forecast on the Euro Area Inflation: Past, Present, and Future

In January 2022, 19 countries that use the euro currency saw an annual increase of 5.1 per cent, which is regarded as the highest boost in rates since recordkeeping since 1997.

Prices are propelling to greater heights due to a number of factors, from the world's early recovery from the COVID-19 pandemic and the continuous, rising spike of oil prices due to the war declared by Russia against Ukraine.

All these political uncertainties caused the euro's energy prices to soar at a whopping 28.6 per cent this February 2022.

The Importance of Maintaining Price Stability in the Euro Area

Maintaining price stability and promoting a sound and efficient single currency are among the top priorities of the European Central Bank. The ECB is therefore in charge of controlling inflation in the euro area.

In order to exercise this control, it keeps the interest rate at a level that is consistent with price stability. This means that the inflation rate is balanced at a rate such that the inflation is close to zero.

Inflation affects the credibility of the euro's ability to store value, and therefore affects the credibility of the euro currency in the global economy. When inflation is too high, people would not want to hold the currency for long.

The Euro Area Inflation Rate: How Is It Calculated?

The Euro Area inflation rate is a combination of the consumer prices of the 19 countries that use the euro as their currency. The consumer price is a combination of the prices of all goods and services such as food, health, education, transportation, clothing, housing, and others.

The consumer price is also an important part of the gross domestic product (GDP), as it can be used to interpret national productivity levels. The consumer price is calculated by comparing the prices that consumers pay for a basket of goods and services in the previous month to the same month from a year earlier.

The calculation of the consumer price index is carried out by the statistical agency of each respective country. When the data is collected, the ECB then publishes it on the ECB website in the reference month.

How is the HICP Calculated? Different Factors to Consider

1. Collecting Prices

The prices of goods and services are collected by the four main sources of data. First, the producer price data is collected from businesses via the harmonized system of national accounts in the country. Second, the data collected in the value-added tax on the margins of businesses.

Third, the data is collected from the information provided by private and public institutions. Lastly, the final data is collected from the retail price sales of both private and public.

In that regard, roughly 1.8 million prices are collected on a monthly basis from over 200,000 shopping outlets in every country. On that note, 700 representatives are put under the spotlight for their prices on their goods and services.

2. Weighting Product Groups

The second step in calculating HICP involves the weighting of product groups. The price data collected is then used in the calculation of the consumer price index (CPI).

The CPI is calculated by comparing the price of goods in the previous month to the previous year using a sample of products. The retail basket of goods and services is then weighted in categories that are meaningful to the residents.

The categories may differ according to the countries, but there are some similarities. They include food, health, transportation, and education.

3. Weighting Countries

The third step in the calculation of the HICP involves the weighting of the countries. These countries include Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain.

This step is used to reflect the importance of each country in the EU, wherein the weight of each country is determined by its economic size and its population.

Why Price Level Indexing Matters

The weights of the components of the consumer price index are implemented according to their importance in the spending of the population. For example, some products such as fuel and tobacco have a high weight in the consumer price index because they are necessities that people cannot do without.

Price level indexes are quite common in the US and the Eurozone. They are used to measure the change in prices. This can be useful in evaluating the effectiveness of the monetary policy.

The advantage of using price level indexes is that they allow inflation to be separated from other cost changes, such as changes in incomes and changes in the quality of goods and services.

Price level indexes are based on the original quantity of an averaged basket of goods and services at a certain point in time. In that regard, it is also believed that price level indexes accurately measure the change in the price level over time.

What is Perceived Inflation?

Perceived inflation is the inflation that the general public sees, feels, and experiences. The perception of inflation can differ from the official inflation, and can also be affected by the actions of the central bank and the spread of financial news.

Seeing as perceived inflation can reflect consumer behaviour, it still plays a pivotal role in the government's decision-making process. Keep in mind that the actual inflation rate is somewhat different from perceived inflation.

Sometimes, the rate of inflation is perceived to be higher or lower than the actual inflation rate. Nonetheless, perceived inflation can be used to measure the time preferences of consumers in order to calculate the real interest rate.

Why Does Perceived Inflation Happen?

Perceived inflation is simply the out-of-pocket inflation that consumers experience. While official inflation measures the change in the price level, perceived inflation measures the personal experience of price-level change.

With that in mind, there are several conditions that may impact the consumers and their perception of the country's current inflation rate:

  • A spike in prices typically garner more attention compared to stable or declining prices;
  • People often pay attention to the prices for common purchases more, such as petrol, bread, bus tickets, and more;
  • People rarely consider the impact of infrequent purchases, such as holidays, cars, and more;
  • People may also notice inflation in their personal experiences, depending on their spending habits. For instance, one may feel the inflation further if he/she constantly uses their car due to the price increase for petrol;
  • There are also quality changes in the products to consider. For example, car prices may be higher than ever, but the features included in their newer, standard models were once sold as extras.

Inflation in the Eurozone: Is It Supply or Demand?

The euro area economy has seen a remarkable recovery since 2016. In fact, it has reached its highest growth rate in 10 years. This economic recovery has been attributed to the robust private consumption and investment in the countries that use the euro currency.

Moreover, the ECB has maintained its monetary policy, which is the low-interest rate. This is due to the risks that would occur if they increase the interest rate now. If they raise the interest rate too early, it will lead to a rapid slowdown in the economy.

On that note, there has been some demand for the euro. From a yield perspective, the lender is better off by holding the euro, which is why the euro has gained against the dollar since the beginning of 2018.

Furthermore, the ECB may decide to cut interest rates in the event of a slowdown in the euro area economy. It will keep the interest rate stable, for the time being, resulting in no further rate hike, eventually returning to the world's pre-pandemic state in comparison to the US.

A Hawkish Approach to Europe's Inflation Path

In the meeting held by the European Central Bank (ECB) on the 3rd of February, 2022, President Christine Lagarde stated that a 2022 rate spike seems "very unlikely." Over this period, markets in the Euro area set the pricing for a ten-basis-point hike to happen sometime this June, forecasting that the ECB's deposit rate will be zero by the end of the year.

New developments also suggest that the inflation in the Euro area is about to hike, resulting in an inflation of 2.5 per cent for 2022 and stabilising at 2 per cent by the end of 2023.

The Bottom Line: The Importance of Keeping Up-to-Date with the Eurozone Inflation

While the euro area has a great potential for growth, the ECB should be cautious with the interest rates. Over the short term, the markets expect higher interest rates to happen soon.

In that regard, the ECB must be careful of the possibility of inflation running too high and damaging growth. This can be especially problematic, especially for countries at risk for a recession.

In the long term, an increase in interest rates is expected in the next year. It may not be in the very near future, but over the medium term, the monetary policy will gradually shift.

On that note, the ECB's monetary policy should be reflective of the economic conditions in the euro area. By the end of the year, there may be a shift in their monetary policy due to the inflationary pressure, which will be a great asset for the Eurozone's recovery, if done properly.

The Eurozone inflation rate is expected to return to its target of less than 2 per cent within one to two years.

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