Chart of the Week: The UK and Euro Area – Will Inflation Continue to Converge?

On average, since its inception, the euro area has experienced weaker consumer price inflation than the UK. Interestingly, the inflation differential has widened since the Global Financial Crisis, with the gap averaging almost one percentage point since 2008.

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With the inflationary impact of the post-Brexit sterling depreciation beginning to ebb, and with rising energy prices accounting for a larger proportion of the euro area’s CPI basket than the UK’s, that inflation differential has narrowed more recently.

Fathom’s Inflation Trends (FIT) model points to a further narrowing this year, as UK inflation drifts toward the Bank of England’s 2% target and firmer core inflation props up the euro area’s headline rate.

Crucially, as we have explained to our clients in more detail, we believe that the euro area’s positive output gap will begin to exert greater upward pressure, allowing core inflation to break out of the narrow band in which it has fluctuated since the middle of 2009.

If we are right, that will pave the way for the ECB to begin hiking interest rates toward the tail end of next year. Meanwhile, with the UK economy in the doldrums, Bank Rate is likely to remain on hold for the foreseeable future.

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