Inflation dynamics: euro area vs the US
As central banks have started their rate cutting cycles, the inflation outlook will be a crucial element in determining their pace. Currently, inflation is lower in the euro area than in the US for both core and headline inflation. However, base effects are more favourable in the US in the next months. Furthermore, in contrast to US CPI, the euro area’s HICP does not include owner-equivalent rent. What is clear, is that the sources of inflationary pressure are different in the US versus in the euro area. The US faces higher rental inflation, while facing lower energy and goods inflation than the euro area. Forward-looking indicators point to favourable inflation dynamics in both economic blocs, however.
As inflation pressures have weakened across the world, central banks globally are starting to cut interest rates. Both the ECB and the Fed have already cut their policy rates by 50 basis points this year and more rate cuts are in the cards. Though central banks are shifting their attention more towards growth and the state of the labour market, inflation dynamics remain a key determinant of the policy rate path going forward. It is thus interesting to compare inflation dynamics in both major economic blocs.
Looking at the latest figures (see figure 1), one might assume that the euro area has made more progress in tackling inflation pressures. Indeed, headline inflation in the euro area was 2.2% in August versus 2.6% in the US. Core inflation was also lower in the euro area (2.8% vs 3.2%). Furthermore, in September’s flash release, euro area inflation declined to 1.8% while core inflation declined to 2.7%. However, a deeper dive reveals a more complicated picture.
More favourable base effects in the US
First, it is important to note that during the next months, base effects are more favourable in the US than in the euro area. Indeed, from September 2023 till February 2024, prices rose 1.6% in the US vs 1% in the euro area. Over the same period, core inflation increased by 1.7% in the US vs 1.2% in the euro area. Thus, if monthly prices were to increase at the same rate in the US and the euro area, year-over-year US inflation would be lower than euro area inflation in 6 months.
Methodological differences between CPI and HICP
Second, there are important methodological differences between the euro area’s HICP-inflation and the American CPI-inflation. The US CPI for example only surveys cities, while HICP is nation-wide. By far the biggest difference, however, relates to how to include housing costs for homeowners. For now, owner-occupied housing costs are not included in the euro area’s HICP (though the ECB has published several preparatory papers on how to include it). In contrast, in the US CPI, a measure of owner-equivalent rent is included. This measure estimates the imputed rent of owner-occupied housing based on the market rents of equivalent dwellings in the same area. As a consequence of this methodological difference, rental costs have far more weight in the US CPI than in the euro area’s HICP (34.5% vs 5.64%).
US inflation figures are also available using the HICP methodology. When comparing both, it is notable that US HICP inflation was only 1.3% in August, much lower than in the euro area (see figure 2).
That said, we can also make an attempt to reconstruct a CPI-index for the euro area by applying the same weight for owner-equivalent rent as in the US and assuming owner-equivalent rent prices in the euro area increase at the same yearly rate as actual rentals for housing. Doing this puts the estimated euro area CPI-inflation below the US CPI inflation (see figure 3).
The discrepancy (apparent contradiction) seen above can be explained by the different composition of inflation in the US vs the euro area. Indeed, because of high immigration and more limited housing supply, rental inflation is far higher in the US than in the euro area (5% vs 2.9% in August). This explains why US CPI is much higher than US HICP measure or even PCE inflation (the Fed’s preferred measure). The weight of rents is namely much higher in the US CPI basket.
In contrast, other inflation components have evolved more favourably in the US than in the euro area. This is especially the case for goods inflation (-1.9% vs 0.4% in August) and to a lesser extent energy inflation (-4% vs -3% in August).
One similarity between both economies is that forward-looking indicators paint a more favourable picture for both. Wage inflation is moderating substantially in both blocs, which will help bring down currently elevated services inflation. Lower oil prices will also push energy prices down in the months ahead (according to futures markets) while low global food prices remain in check. Even rents are likely to come down. This is especially the case in the US where new-tenant-rents were 1.1% lower than a year ago.
Conclusion
Though inflation dynamics seem more favourable (lower) in the euro area than in the US at first glance, the reality is more complicated. Base effects are more favourable in the US and there are important differences in methodology. What is clear, is that the composition of inflation is different in both blocs. Rental inflation is far higher in the US, while goods and energy inflation is higher in the euro area. That said, forward-looking indicators paint a more positive picture for both economic blocs.