Eurozone Inflation Outlook: Implications for ECB Policy

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1 Economics Group Special Commentary Executive Summary The European Central Bank (ECB) has not done a very good job of hitting its inflation target of below, but close to, 2 percent over the past few years. In an attempt to stoke inflation, the Governing Council slashed its main policy rates to unprecedentedly low levels and it implemented a QE program, which is still in place. The overall inflation rate has moved higher this year, due largely to a rebound in energy prices, although the core rate of inflation, which is a good measure of underlying inflation pressures, remains well short of 2 percent. If the overall rate of inflation in the Eurozone trends slowly higher in the months ahead as our analysis suggests, then we think the conditions will be in place for the ECB to eventually dial back policy accommodation. Specifically, we look for the Governing Council to end its bond purchases in late 2018, and we expect it to begin a slow process of rate hikes beginning in early The ECB s Elusive Inflation Goal The ECB has a single mandate to deliver price stability, which it defines as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below, but close to, 2 percent over the medium term. On that basis, the ECB has largely failed to fulfill its mandate over the past few years (Figure 1). For example, the overall HICP rose only 0.2 percent in Some of this undershot in the overall rate of inflation last year was due to sharp declines in energy prices, which the ECB cannot control. However, the core rate of inflation, which excludes energy and other goods with volatile prices and which is a good measure of the underlying pace of inflation, was up just 0.9 percent in Clearly, the core rate of inflation was higher than the overall rate of inflation last year, but it was hardly close to 2 percent. Jay H. Bryson, Global Economist jay.bryson@wellsfargo.com (704) Azhar Iqbal, Econometrician azhar.iqbal@wellsfargo.com (704) Abigail Kinnaman, Economic Analyst abigail.kinnaman@wellsfargo.com (704) Eurozone Inflation Outlook: Implications for ECB Policy The ECB has largely failed to fulfill its inflation mandate over the past few years. Figure 1 Figure 2 Eurozone Consumer Price Inflation Year-over-Year Percent Change CPI: 1. Core CPI: 0.9% 6% ECB Policy Rates ECB Refinancing Rate: 0.0 ECB Deposit Rate: -0.4 ECB Marginal Lending Rate: 0.2 6% Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 In response to the below-target rate of inflation, the Governing Council of the ECB slashed its main policy rates to unprecedentedly low levels (Figure 2). Notably, it took its deposit rate the rate that it pays commercial banks on their deposits at the ECB into negative territory starting in June As we discuss further below, the ECB also embarked on a quantitative easing (QE) program starting in early Over the past two years, the size of the ECB s balance sheet has ballooned to nearly 4.4 trillion from about 2.1 trillion (Figure 3). Figure ECB Balance Sheet Trillions of Euros ECB Balance Sheet: 4.37T The inflation picture in the euro area may be starting to slowly change. Our model suggests that inflation in the Eurozone will trend slowly higher in coming quarters. Source: Bloomberg LP and Wells Fargo Securities However, economic growth in the Eurozone is strengthening the year-over-year rate of real GDP growth reached a six-year high of 2.5 percent in Q and the inflation picture in the euro area may be starting to slowly change. The overall HICP was up 1.4 percent on a year-ago basis in October and the core rate of inflation is marginally higher today than it was about a year ago. Using a model that we developed in 2014, we forecast HICP inflation in the Eurozone for the next two years, which we then use to inform our views about ECB monetary policy going forward. 1 Are Inflation Dynamics Starting to Change? As described in more detail in our 2014 report, we model HICP inflation in the euro area as a function of the output gap (i.e., the difference between actual GDP and potential GDP as a percent of the latter), long-run inflation expectations and the euro price of Brent oil. As shown in Figure 4, our model does a reasonably good job of estimating actual inflation in the Eurozone over the last twenty years. That said, its current estimate of inflation is ½ percentage point below the actual rate of inflation at present. When oil prices swing wildly, as they have over the past few years, the errors in our model tend to get larger until the volatility subsides. Using our forecasts of GDP growth, inflation expectations and oil prices, our model suggests that the HICP inflation rate in the Eurozone will trend slowly higher in coming quarters. Our GDP forecast implies that the output gap in the euro area will narrow further. That is, the actual rate of real GDP growth in the Eurozone should remain above the long-run potential growth rate over the next few quarters, which should put some upward pressure on inflation. However, inflation only creeps higher over the forecast period because our estimate of long-run inflation expectations stays firmly anchored and our forecasted euro-denominated price of oil remains more or less stable. Taken literally, our model suggests that the HICP inflation rate will remain well-below 2 percent through the end of As noted above, however, our model is currently under-forecasting the actual inflation rate by ½ percentage point. If, as our model predicts, inflation trends slowly higher from its actual rate at present (i.e., 1.4 percent), then it will approach 2 percent by the end of See Does Deflation Threaten the Eurozone? (February 28, 2014) and Deflation in the Eurozone Reconsidered (May 21, 2015). Both reports are available upon request. 2

3 Figure 4 Figure 5 Estimates of Inflation in Eurozone Year-over-Year Percent Change Actual CPI Inflation Rate: 1. Model Estimate: 0.9% Forecast: The 6-Months Ahead Probability of Price Scenarios in the Eurozone Probability of Inflationary Pressure (CPI > 2.2) Probability of Stable Prices (1.2 CPI 2.2) Probability of Deflationary Pressure (CPI < 1.2) Source: IHS Global Insight and Wells Fargo Securities As a check on our forecast, we also follow the methodology we employed in our 2014 and 2015 reports in which we estimate the probabilities of deflationary pressure, stable prices and inflationary pressure. We define stable prices as an inflation rate between 1.25 percent and 2.25 percent six months from now, inflationary pressure as an inflation rate in excess of 2.25 percent, and deflationary pressure as an inflation rate less than 1.25 percent six months from now. Figure 5 shows how these probabilities have evolved over time. From mid-2013 through mid-2016 our model suggested that the probability of deflationary pressure was 50 percent or greater. In the event, the actual inflation rate consistently fell short of 1.0 percent over this entire period, so our model did a good job of predicting the actual inflationary experience in the Eurozone during this period. At present, the probability of deflationary pressure six months from now has receded to about 30 percent. Correspondingly, the probability of stable prices has risen to about 50 percent, and the probability of inflationary pressure is up to roughly 20 percent. In short, our probability model generally corroborates the findings of our forecast model, which suggests that inflation in the euro area should trend slowly higher in coming quarters. Implications for ECB Policy Going Forward As noted previously, the ECB has had a QE program in place since early The Governing Council dialed back its monthly rate of bond purchases earlier this year to 60 billion from 80 billion, and it recently announced another taper in its monthly purchase rate. Specifically, the ECB will purchase only 30 billion worth of bonds beginning in January 2018, and it intends to keep this monthly purchase rate unchanged through at least next September. If the overall rate of inflation in the Eurozone trends slowly higher in the months ahead as our analysis suggests, then we think the conditions will be in place for the ECB to end its bond purchases in late Assuming that new bond purchases end in late 2018, we also think that the ECB would be in a position to start hiking its policy rates in early In our view, the Governing Council would raise its deposit rate before changing its other two traditional policy rates (i.e., its two-week refinancing rate and its marginal lending rate). Specifically, we think the Governing Council will make its deposit rate less negative (it could raise it to percent), while keeping its other two policy rates unchanged initially. Its next move would be to take the deposit rate to 0.00 percent while also hiking its two-week refinancing rate and its marginal lending rate. However, the ECB likely will not need to hike rates at a fast pace if, as our analysis suggests, inflation trends only slowly higher toward 2 percent. Specifically, our forecast calls for the two-week refinancing rate, which currently stands at 0.00 percent, to rise to only 0.50 percent at the end of The probability of deflationary pressure in the Eurozone is receding. We think the ECB will begin to slowly raise rates in

4 Conclusion The ECB has not done a very good job of hitting its inflation target of below, but close to, 2 percent over the past few years. In an attempt to stoke inflation, the Governing Council slashed its main policy rates to unprecedentedly low levels and it implemented a QE program, which is still in place. The overall inflation rate has moved higher this year, due largely to a rebound in energy prices, although the core rate of inflation, which is a good measure of underlying inflation pressures, remains well short of 2 percent. If the overall rate of inflation in the Eurozone trends slowly higher in the months ahead as our analysis suggests, then we think the conditions will be in place for the ECB to eventually dial back policy accommodation. Specifically, we look for the Governing Council to end its bond purchases in late 2018, and we expect it to begin a slow process of rate hikes beginning in early

5 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (704) Michael A. Brown Economist (704) Jamie Feik Economist (704) Erik Nelson Currency Strategist (212) Michael Pugliese Economic Analyst (704) E. Harry Pershing Economic Analyst (704) Hank Carmichael Economic Analyst (704) Ariana Vaisey Economic Analyst (704) Abigail Kinnaman Economic Analyst (704) Shannon Seery Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2017 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE