yves mersch : is inflation back? keynote address by mr yves mersch, president of the central bank of luxembourg and member of the governing council of the european central bank, at the bank finance 2011 conference, frankfurt am main, 3 march 2011. * * * headline inflation in the euro area is on the rise. according to eurostat ’ s flash estimate euro area annual hicp inflation increased by 0. 1 percentage points to 2. 4 % in february. this figure is more a snapshot than an incipient violation of the ecb ’ s medium - termoriented definition of price stability, – namely of inflation below but close to 2 % –, but there is no room for complacency. the key question is whether we are facing a “ hump ” – in other words, is this acceleration in headline inflation temporary –, or is it the edge of a plateau, where the pressure on prices is more persistent than currently assumed. the judgment on this is three - forked : we envisage a good, a bad and an ugly scenario. the good scenario, i. e. the good news, is that we have been here before. temporary increases in headline inflation have not prevented the ecb from managing to keep the average annual inflation rate in the euro area at 1. 97 over the past 12 years. the bad news is that things might be slightly different this time, as forecasting inflation is, indeed, a complex task. the really ugly news is that there may be even drivers at work that could lead to errors in forecasting inflation significantly, especially in underestimating future price levels. let me discuss this in more detail. the good scenario : the hump scenario is the most benign annual headline inflation in the euro area increased steadily in the course of 2010, from 1. 0 % in january to 2. 2 % ( in december, an increase of 1. 2 percentage points within one year. this 11 - month increase in headline inflation is due ) almost entirely to the food and energy components of the hicp. crude oil prices, for example, have surged by around 35 % over the last half year, peaking above 120 dollar very recently, and pushing up import prices. recent political turmoil in some oil exporting countries in the arabian world may lead to further price increases. the contribution from the other components of the hicp basket was relatively stable, though mildly accelerating. according to the consensus among monetary authorities, these sources of price pressure

core inflation was concerned. the projection of the head line inflation, however, was systematically too low, because – among other reasons – the scale of the pass - through of past energy or commodity price shocks into output prices has been underestimated. secondly, upward risks to headline inflation stem from pronounced base effects. base effects occur when variations in the annual growth rate of the hicp are the result of an atypical movement in the index in the base period. they tend to be particularly influential during periods when inflation volatility 12 months earlier was high, for example as a result of sharp movements in commodity prices. it is expected that 2011 will benefit from negative cumulative base effects from energy and food in 2010 of up to 0. 7 percentage points. thirdly, the choice of leading sub - indicators is a tricky one. let me give an example. in recent years energy prices, namely for crude oil, contributed to an increasing extent to the volatility of headline inflation. there is, in fact, not just one price for “ oil ”. traditionally west texas intermediate ( wti ) commands a higher price than brent crude. most recently the price differences between the two benchmark sorts of crude oil showed anomalies : on 1 march, wti was trading around 100 us dollar per barrel, while brent was at 114 us dollar per barrel. while this huge difference could be partially explained by regional factors like the cold winter in europe and the large stock of wti oil in the us, the reliability of these prices to signal global scarcity can be questioned. fourthly, one major driver of inflation is the dynamics of the economy. to measure the slack in the economy, the deviation of aggregate demand from the economy ’ s potential supply – the so - called “ output gap ” – is often seen as a helpful guide for policymakers. on this logic, inflation rises, when aggregate demand exceeds potential output. however, the concept of a stable relationship between output gap and inflation is not only frequently challenged in theory but also hard to apply in practice. the operational appropriateness of the output gap as a guide to policy is limited by the availability of reliable real - time estimates. for example, estimates of the euro area output gap, as published by international organizations from 1999 to 2004, underwent significant revision. some revisions matched or even exceeded the original estimate of the gap itself. bis central bankers ’ speeches complexity has increased further because of the financial crisis : in this context, the crisis has had