Euro area inflation surprises on the upside will core inflation follow the upward trend?

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1 Euro area inflation surprises on the upside will core inflation follow the upward trend? Pernille Bomholdt Henneberg Senior Analyst / January 2017 Investment Research Important disclosures and certifications are contained from page 16 of this report.

2 Euro area inflation surprises on the upside will core inflation follow the upward trend? Euro area inflation increased to 1.8% y/y in January, which is the highest rate since February 2013 and above consensus at 1.5% y/y. The rise in inflation was driven mainly by energy and food price inflation, which together had a contribution of 1.1pp up from 0.5pp in December. Core inflation was unchanged at 0.9% y/y in January and has therefore not been above 1.0% since October The unchanged core inflation reflected a 0.1pp decline in service price inflation, whereas non-energy industrial goods price inflation was up by 0.2pp. Higher inflation was seen across countries Spanish inflation was 3.0% and significantly above the ECB s 2% target hence, the ECB can conclude that it is not only German inflation that is higher. That said, it still remains to be seen whether the rise in inflation will affect the medium-term horizon and whether it is a durable, self-sustained convergence. We expect core inflation to stay low at 0.9% on average this year, primarily as labour market slack in the periphery countries should keep wage growth subdued. Core inflation will, in our view, be supported by an indirect impact of the higher oil price but this should not be enough to bring core inflation persistently above 1.0%, as there is less tailwind from a euro depreciation (see more about the main drivers of core inflation below). The bottom line is that we do not expect the higher inflation figures to change the ECB s monetary policy stance, as the underlying price pressure is still weak. Although some ECB members have started to express a more hawkish stance recently, consensus in the ECB seems to be that core inflation also needs to rise before the ECB will discuss tapering. We still believe the ECB will announce a third QE extension this year. 1

3 Euro area inflation surprised on the upside in January Higher inflation across euro area countries Inflation set to continue higher in Feb, then lower Source: Eurostat, Danske Bank Markets Note the Italian figure is from December the January figure will be released on Friday. Source: Eurostat, Danske Bank Markets 2

4 Food and energy price inflation main drivers of higher inflation Energy prices following the oil price increase Unprocessed food price inflation rose in Jan Source: Bloomberg, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets 3

5 Core inflation set to stay low during 2017 Drivers of core inflation: Core inflation set to stay low during Output gap changes affect profit margins 2. Labour market development affects wage growth 3. Indirect effect of commodity prices 4. Exchange rate development 5. Inflation expectations Source: ECB, Eurostat, Danske Bank Markets 4

6 #1: The closing output gap points to higher core inflation Core inflation could rise as output gap closes But periphery output gap also needs to close Source: ECB, European Commission, Eurostat, IMF, OECD, Danske Bank Markets Source: European Commission, Eurostat, Danske Bank Markets Note the country figures are from December 5

7 #2.1: Low core inflation as long as wage growth stays low Low service price inflation as wages stay low Philips curve: ECB s wage forecast is hopeful ECB 2019 Wages: 2.4% Unemp: 8.7% ECB 2018 Wages: 2.1% Unemp: 9.1% ECB 2017 Wages: 1.7% Unemp: 9.5% ECB 2016 Wages: 1.2% Unemp: 10.0% Source: ECB, Eurostat, Danske Bank Markets Source: ECB, European Commission, Eurostat, Danske Bank Markets 6

8 Service price inflation % y/y #2.2: Periphery labour market slack will keep euro wages low Large unemployment gap in the periphery Low service price inflation due to slack Long-term unemployment rate and service price inflation AT BE FI IE PT DE German service price inflation remains low and is not lifting the euro area aggregate FR EA IT y = -0.12x SP 0.25 NL Long-term unemployment rate (change since 2008) Source: European Commssion, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets Note the service price inflation figures are from September in line with the long-term unemployment figure 7

9 #3: Past euro weakening supported core inflation Core inflation from 0.6% to 1.1% in 2015 The euro weakening lifted core inflation Source: Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets 8

10 #4.1: Indirect, lagged impact of the oil price on core inflation The oil price signals higher NEIG inflation and also higher service price inflation Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets 9

11 #4.2: Oil-sensitive components play a modest role for core inflation Higher NEIG as oil impact kicks in in end-17 Transport to lift service price inflation a bit Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets 10

12 #5: Rising selling price expectations but a very poor indicator Expected and actual inflation not correlated Service PMI, output prices are not helping Source: European Commission, Eurostat, Danske Bank Markets Source: Eurostat, Markit PMI, Danske Bank Markets 11

13 Bottom line: subdued core inflation ECB is overly optimistic Service price inflation set to remain low Core inflation set to rise less than ECB expects Source: Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets Note the country figures are from December 12

14 QE extended again as ECB will not see higher underlying prices Mario Draghi s definition of the ECB s objective: Higher inflation, but not really close to 2% We define our objective first of all in the medium term, over a medium-term horizon. That's the relevant policy horizon. Second, it has to be a durable convergence, so it cannot be transient. Third, it has to be self-sustained. In other words, it has to stay there even when the extraordinary monetary policy support that we are providing today will not be there. Fourth, it has to be defined for the whole of the eurozone. Source: ECB, Eurostat, Danske Bank Markets 13

15 The market is no longer pricing in deflation, but 5Y5Y not yet 2% 5Y5Y inflation exp. not back around 2% level The entire inflation curve is affected by spot 2.50 % y 1y 2y 2y 5y 5y 10y 10y 0y 5y 10y 15y 20y 25y 30y 35y 40y 45y 50y Current Average since 2014 Max/min since 2014 Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 14

16 The market is pricing in lower inflation again in early 2018 Inflation is priced down at 1.3% in Y1Y inflation much higher since summer 2.00% 1.50% 1.00% 0.50% 0.00% The market is pricing inflation at only 1.3% on average in 2019 vs. ECB's projection of 1.7% -0.50% -1.00% Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 HICP inflation Market pricing ECB inflation forecast (December) Danske inflation forecast Source: Bloomberg, ECB, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 15

17 Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The author of the research report is Pernille Bomholdt Henneberg, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. 16

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