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How much can the CPI fall?

Written by A Forex View From Afar on Thursday, January 08, 2009

The Euro-area CPI data has taken a deep plunge recently. During the summer of 2008, the CPI reached record highs, but has decline at a very fast pace during the past few months.

The Euro-area CPI dropped from a record 4.0% in June and July, to December’s unconfirmed number of 1.6%. This is a huge drop, but the question now is ‘how low can it actually drop from now on?

Theoretically, there is no limit to how much the CPI can fall, since it can go all the way below the zero benchmark. However, there is a practical limit to how low the inflationary read can drop.

In the last period, the CPI was dragged lower by huge declines in the crude oil market. At the same time, crude oil was to blame for the huge increases seen in the CPI during the early part of 2008.

Up to now, the month of January has brought something new in the crude oil market. The commodity managed to find a bottom, and actually posted some small gains. This means though, the CPI read might have found a bottom too, and the huge declines might stop, at least if oil does not move any lower.

As seen in the attached chart, crude oil (priced in euros) and the Euro-area CPI read moved hand in hand over the last five years. The correlation between the two, oil and Euro-area CPI, over this period is very high, slightly above 80%. Because the way the CPI is built, to absorb asset shocks over a longer period, it has the tendency to follow the oil market with a small lag.


Assuming that the oil market has hit the bottom, as most say it has, we can deduce the CPI read will not go any lower in Europe or in the other major economies. However, because of the CPI’s lag, we might see it coming down for a while, but soon the read will hit a bottom too, hopefully skipping any negative read.

If this holds true, central banks will not have the same initiative to cut interest rates, as they have up to this point. In Europe, the CPI read was the main reason why the central banks have cut so much, being in danger of “undershooting” the target. Maybe, no other bank will join the Fed and the BoJ in their quantitative easing path.

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