Investment Research General Market Conditions 05 March 2015 Euro inflation research #1 Inflation to increase sharply this year Euro inflation surprised on the upside in February and consequently we revise our forecast for 2015 up and into positive territory. The upward revision is driven by higher energy and food price inflation. Historically, commodity prices have explained most of the variation in inflation. At the end of 2015 we expect inflation to increase sharply as there is a positive base effect from the decline in the oil price in 2014. Although headline inflation is set to increase we forecast core inflation will stay below 1.0% during 2015 and we look for a new historical low of 0.5% in April. Continued low core inflation should follow as wage growth will remain weak due to a large amount of slack in the labour market. Inflation forecast above consensus Euro area 2015 2016 forecasts GDP HICP GDP HICP Danske Bank 1.5 0.1 2.0 1.5 Consensus 1.2-0.1 1.6 1.2 ECB 1.0 0.7 1.5 1.3 EU Commission 1.3-0.1 1.9 1.3 OECD 1.1 0.6 1.7 1.0 Source: Bloomberg, ECB, European Commission, OECD, Danske Bank Markets The ECB s QE programme reduces headwind to inflation through a weaker currency, but changes in commodity prices have a larger impact on inflation. Inflation forecast revised higher Following the higher than expected HICP inflation in February we have revised our forecast up and we no longer expect deflation in 2015 on average. Instead we expect inflation to be +0.1% in 2015 up from a previous forecast of -0.3%. We have also lifted our 2016 forecast a bit to 1.5% from 1.4%. This implies that our forecast is now above consensus in both 2015 (-0.1%) and 2016 (1.2%). We still expect the euro area to remain in deflation during H1, but at the end of the year it should rise sharply as there is a positive base effect from the large drop in the oil price at end-2014. Inflation to increase sharply in end-2015 Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
Food and energy prices explain most of the variation in inflation The positive surprise to inflation in February mainly followed due to higher-thanexpected inflation in both food and energy prices. Generally, food and energy price inflation are volatile and the surprise reflects they account for the largest share of the absolute monthly variation in annual inflation. Energy price inflation explains above 50% of the monthly variation in headline inflation although it only has a weight of 10%. Low inflation due to low energy price inflation Food and energy prices explain most of the inflation variation Looking ahead, we expect the negative contribution from energy price inflation to fade. This reflects that it is highly dependent on oil prices and we expect Brent will recover to USD76/bl on average in Q4, see Research Commodities: Bumpy road to oil price recovery déjà vu #4. However, even if the oil price remains unchanged at the current level the contribution from energy price inflation will converge towards zero and headline inflation will print positive as we expect core and food price inflation to continue to have a positive contribution to headline inflation. Food price inflation should remain positive, but we expect it to be low in a historical perspective. In 2014 food price inflation declined and printed negative for three months in a row. This followed after it had a positive impact of 0.6pp on average in 2012-13. In terms of global grain and oilseed prices we expect prices to trend higher on looming weather risk, but low oil prices will reduce demand for grain and oilseeds for bio energy and production and thus limit upside price potential, see Research Commodities: Grain and oilseed prices to trend higher this year and next. Based on this we expect food price inflation to stay positive, but at a low rate compared to what has been seen recently. Higher oil price to lift energy price inflation Food price inflation to remain low in a historical perspective Source: Bloomberg, ECB, Danske Bank Markets Source: Hamburg Institute of International Economics, Eurostat, Danske Bank 2 05 March 2015 www.danskeresearch.com
Downside risk to service price inflation for a long time The latest decline in headline inflation gives downside risk to service price inflation. This follows as the service sector is highly dependent on labour as an input and wages are likely to follow inflation and inflation expectations lower. Lower wage growth would follow due to wage indexation but could also be seen under wage negotiation processes as the low inflation makes it easier for employers to argue for low nominal wage growth. Consequently, low inflation expectations increase the risk of the dangerous kind of deflation where wages are also declining. Service price inflation likely to follow headline inflation lower Low inflation expectations increase risk of low wage growth Source: ECB, Danske Bank Markets Going forward, we expect service price inflation to remain low, although the labour market continues to improve. The short-term unemployment rate has been a good leading indicator for wage growth, but in 2014 they have diverged. In our view, this reflects second-round effects related to the oil price decline and the large amount of slack in the labour market in the euro area. Compared to the US the unemployment rate is still far from a structural level and even within our forecast horizon we do not expect the actual rate to reach it. In the US, wage inflation remains subdued despite a rapid improvement in the unemployment rate following the recession. In February, service price inflation was slightly higher but we do not see it as a turnaround. Instead, we see it as more likely that it was due to the volatility in some of the sub-components. Related to that the timing of Easter in 2015 should imply core inflation will increase in March but decline to a new historical low of 0.5% in April. Wage growth has not followed progress in labour market Euro unemployment rate far from the structural level Source: ECB, Eurostat, Danske Bank Markets Source: Bureau of Labour Statistics, Eurostat, Danske Bank Markets 3 05 March 2015 www.danskeresearch.com
ECB s QE programme reduces headwind to inflation The ECB s QE programme should support inflation expectations as it signals the ECB is committed to its mandate of maintaining price stability. Hence, the monetary easing should support wage growth if the stimuli convinces wage earners that they should expect 2% inflation. Related to this the easing should limit second-round effects and the risk of a dangerous kind of deflation, where wages follow inflation lower. Added to this there should be upward pressure on prices due to the currency depreciation. The effective exchange rate has weakened more than 10% since May 2014 when Draghi signalled the ECB would ease monetary policy. This is estimated to lift headline inflation by 0.3pp in 2015 and the impact should increase to 1.0pp in 2017 if the exchange rate remains around the current level. ECB easing has weakened the effective euro The weaker euro supports inflation Source: Bloomberg, Danske Bank Markets Source: OECD, Danske Bank Markets The main impact of the euro depreciation should be seen in non-energy industrial goods, where it gives higher imported inflation. Although the currency has weakened since May 2014, inflation in non-energy industrial goods has trended lower for more than two years and it has a small negative impact on core inflation. However, this is likely to reflect that industrial goods prices are indirectly affected by the decline in the oil price as it reduces producer prices. Added to this the effective euro appreciated from mid-2012 to mid-2014 and as some of the impact comes with a lag it continued to be a headwind to inflation. The oil price also affects industrial goods inflation The decline in core inflation is mainly due to industrial goods Source: Bloomberg, Eurostat, Danske Bank Markets 4 05 March 2015 www.danskeresearch.com
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