Euro area: The importance of domestic inflation guiding ECB policies

• Domestic inflation has played a central role in the ECB's reaction function to meet its price stability objective, and it is therefore key to understand its drivers as it in turn influences the level of the policy rate. ECB has developed the so-called 'LIMI' indicator of domestic inflation to gauge the inflation pressure in the categories that are mainly affected by domestic demand. This piece reviews the 'LIMI' indicator and discuss the implications for monetary policy.

• The recent underlying inflation pressure is primarily domestically driven, with the main driver being labour intensive sectors such as recreational services (restaurants and hotels). We expect the strong momentum in domestic inflation to continue due to strong services demand in the economy, low unemployment rate, and strong wage growth. As a result, we do not foresee the annual growth rate of domestic inflation reaching 2% in the coming 12 months, amid headline HICP hitting 2% in later this quarter.

• Uncertainty surrounding the drivers of domestic inflation and its future trajectory remains high. We find that 'LIMI' inflation is mainly driven by wage growth, although not solely. The strong domestic inflation and uncertainty surrounding its drivers and their outlooks, particularly wage growth, mean that the ECB must maintain a sufficiently restrictive policy rate to ensure that inflation aligns with the medium-term objective of price stability.

Domestic inflation is particularly important for the ECB’s price stability objective

The ECB’s primary objective is to maintain price stability, which in turn the Governing Council has defined as year-on-year increases in HICP-inflation for the euro area of 2% over the medium term. As the inflation objective is formulated in terms of headline HICP over the medium term, it is important to distinguish temporary idiosyncratic shocks from signals on medium-term inflationary pressures. To separate signals from noise, the ECB track various underlying inflation measures, which are designed to identify short-term volatility in headline HICP inflation. The measures of underlying inflation can broadly be categorised as either exclusion measures (core inflation, trimmed mean), cyclicality-based measures (super core) and frequency-based measures (PCCI).

While the ECB monitors a broad range of underlying inflation measures, their recent focus since last summer has particularly been on domestic inflation, which can e.g. be measured by the so-called LIMI indicator. The July ECB meeting press release even stated that “While some measures of underlying inflation ticked up in May owing to one-off factors, most measures were either stable or edged down in June […] At the same time, domestic price pressures are still high”. The notion of domestic inflation is analytically important for monetary policy due to its central role in the transmission mechanism of monetary policy. The ECB’s monetary policy mainly affects domestic demand and thereby domestic prices, while only to a smaller extend global demand and prices. Thus, domestic inflation is a basket of items that ECB’s monetary policy have a relative direct impact on.

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