Itaú BBA - Is service-price disinflation in line with fundamentals?

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Is service-price disinflation in line with fundamentals?

October 10, 2016

We show that the recent evolution of service-price inflation is in line with economic fundamentals.

• In recently published documents, the Central Bank has reiterated that for monetary easing to occur the “IPCA components that are most sensitive to monetary policy and economic slack should show disinflation at an appropriate pace.” According to the committee, however, signs indicating the pace at which these items are falling are still inconclusive.

• We show that the recent evolution of different service-price inflation components is in line with economic fundamentals.

• Labor-market deterioration and lower inflationary inertia suggest that service-price inflation is retreating, corroborating our scenario of a cycle of interest rate cuts beginning in 2016.

Recent evolution of service-price inflation:

Inflation in the service sector has been slowing since the end of 2015. In June 2016, this item reached its lowest level since mid-2010 (7.0%), but it has increased again in July and August, raising questions about the disinflation pace.

The drop in service-price inflation can be observed in both the full index (Chart 1) as well as the underlying inflation indicator (chart 2) presented by the central bank in its most recent Inflation Report. This indicator is constructed by excluding four groups of prices from service inflation: tourism, domestic services, courses and communications.[1] By excluding these groups (which increase infrequently and whose variation calculation has undergone a recent methodological change), it is easier to identify the inflationary trend.

Charts 1 and 2 show cumulative inflation between January and September of each year since 2004. In 2016, service inflation dropped to 4.9%, from 5.9% in the same period of 2015, reaching its lowest cumulative value since 2007. We can see similar behavior in the underlying service-sector inflation indicator, which fell to 5.0% in 2016 from 7.4% over the same period in 2015.

Service-price inflation dynamic is related to labor market conditions and inflationary inertia. Between 2011 and mid-2015, the unemployment rate remained below 9%[2] despite lower economic growth, keeping service-price inflation under pressure at around 8%-9% per annum. It was only at the beginning of 2015 that unemployment started to rise. However, under the influence of inflationary inertia, service-price inflation ended last year at 8.1%. In the Brazilian economy, past inflation is used as a benchmark to calculate many price increases, including adjustments to the minimum wage, which means the effects of higher inflation tend to propagate over the following years.

Chart 3 shows that service-price inflation is related to both past inflation (inertia) and the unemployment rate. Last year, unemployment rose but inertia also rose, keeping service-price inflation high. This year, however, despite the fact that inertia is still elevated, the high level of slack in the economy contributed to a drop in service-price inflation, in line with fundamentals.[3]

Using an econometric exercise that takes into account past inflation and unemployment (see table in the appendix), we found that, had cumulative twelve-month inflation remained at its historic average (6.5%, the average level between 1997 and 2015), year-over-year service-price inflation in September 2016 would be at 4.7% (instead of 7.0%), given the unemployment observed. On the other hand, if unemployment was lower (9%, the average level observed between 1997 and 2015), service-price inflation would be at 7.7% in September 2016, given year-over-year inflation observed. This exercise shows that both economic fundamentals, slack and inertia, affected service-price inflation evolution in 2015.

Evolution of the main sub-items comprising service-price inflation:

In order to verify whether the recent drop is linked with the fundamentals, we have analyzed the correlation between each service-price inflation sub-item and the index that takes into account both past inflation (inertia) and the unemployment rate. Chart 4 shows that the sub-items that fell the most between November 2015 and September 2016 are those with highest correlation to the index, supporting that the recent drop in service-price inflation is linked with economic fundamentals.

One item in service-price inflation warrants our attention. Food away from home (which represents 25% of service-price inflation) is explained by the dynamic of both food at home and the labor market (the econometric exercise is attached). Throughout 2016, poor weather conditions drove up prices of various fresh fruits and vegetables, putting pressure on food-at-home inflation. Looking ahead, we forecast that price pressure from food will continue to dissipate, contributing to a drop in the food-away-from-home sub-item and, consequently, service-price inflation.

Conclusion:

We have assessed that the recent evolution of service-price inflation is happening at an appropriate pace, that is, in line with economic fundamentals (labor market and inflationary inertia). Looking ahead, even if inflation remains under pressure, the still-significant level of idle capacity in the economy and deteriorating conditions on the labor market will result in salary cost moderation. In other words, the recession will likely have a significant role to play in service-price disinflation.


 

Julia Gottlieb

Laura Pitta 

Thales Caramella



[1] For more details: http://www.bcb.gov.br/htms/relinf/port/2016/09/ri201609b4p.pdf

[2] Rate of unemployment measured by Seade. We use this measurement because it is the longest unemployment series available.

[3] The same can be said for underlying service inflation and can be observed in chart 5.


 



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