Part 3: Scandi Inflation The diverging Phillips curves in Norway and Sweden

Investment Research General Market Conditions 28 February 2018 Part 3: Scandi Inflation The diverging Phillips curves in Norway and Sweden Inflation and markets In this third document in our series, we focus on inflation in Scandinavia. The Scandinavian economies are rather similar in structure but their inflation outlooks are very dissimilar, as wage dynamics and local business cycles differ. We expect Swedish inflation to surprise on the downside both relative to the Riksbank s expectations and market pricing. Service price inflation is set to fall on muted wage growth and one-off factors. The Phillips curve has broken down, which may be due to low realised inflation feeding into wage negotiations. In contrast, the Phillips curve is alive and kicking in Norway where wages are responding to a tightening labour market through higher wage drift. We expect wage growth in Norway to rise to 3% in 2019, pushing domestic inflation higher. Historically, Danish inflation is very correlated with the euro area where a drop in 2018 due to temporary factors should be followed by higher inflation in 2019, surpassing market expectations. In this piece, we describe our inflation outlook and the risks for Sweden, Norway and Denmark and highlight the most important reasons why there are substantial differences between those outlooks. We focus on some of the same factors which we believe impact global and eurozone inflation outlined in respectively Part 1 and Part 2 of this series while stressing the special domestic factors in each of the Scandi countries. Sweden: low cost growth, low inflation In Sweden, we expect CPIF, the measure the Riksbank tracks, to move lower over the course of 2018-19. In Sweden, CPIF inflation is basically determined from the cost side. Domestic inflation is essentially service price inflation which is in principle determined by nominal wage growth. As domestic inflation constitutes roughly 70% of CPIF (the measure that matters for monetary policy), this is also the prime determinant of inflation. FX movements which affect imported inflation, constituting the remaining 30%, is the other important driver of CPIF. This is mostly goods. Of course in the background, there is a global price level of traded consumer goods, presumably largely determined by inflation in the largest producer of consumer goods, China. In addition, inflation is directly affected by energy prices domestic inflation by electricity prices and imported inflation by fuel prices (petrol). Part 1: Global inflation, 26 February Part 2: Eurozone inflation, 27 February Part 3: Scandi inflation, 28 February Part 4: FX implications, 1 March Part5: FI implications, 2 March Table1. Our headline CPI forecast (market pricing in brackets) 2017 2018 2019 Sweden 1.8 1,5 (1,6) 1,3 (1,7) Norway 1.9 1.9 2.0 Denmark 1,1 0,9 (0,9) 1,4 (1,1) Note: Market pricing is interpolated from inflationlinked bonds. Due to lack of market liquidity, we have left out Norway in terms of market pricing. Chart 1.Swedish inflation is set to fall and the opposite is the case in Norway Note: Denmark does not have an inflation target. Table 2. Very different inflation risks in the Nordics for 2018-19 Chief Economist, Denmark Las Olsen +45 45 12 85 36 laso@danskebank.dk Chief Economist, Sweden Michael Grahn +46 8 568 80588 mika@danskebank.dk Source: Danske Bank Chief Economist, Norway Frank Jullum +47 45 25 85 29 fju@danskebank.dk Global Head of FICC Research Thomas Harr, PhD +45 45 13 67 31 thhar@danskebank.dk Important disclosures and certifications are contained from page 7 of this report. www.danskeresearch.com

For CPI inflation, mortgage rate developments have to be added, as part of domestic inflation. No signs of higher wage growth The Swedish wage round last year struck a three-year central agreement, the deal was for 2.2% per year. There are no signs of wage drift despite record high levels of labour scarcity (see Chart 3), an indication that the Phillips curve has broken down and become flat (see Chart 4). Swedish wage formation is very centralised, starting with a deal struck by social partners in manufacturing. This is to preserve the export industry s competitive power, mainly with an eye to German industry. In this regard, the rise in wage growth for German electro and metal workers described in Part 2: Eurozone inflation Upside risks from oil prices and wage growth, 27 February, should be watched carefully but so far there are no signs of rising wage pressures in Sweden. The level set in Sweden s industrialised sector is then basically transferred to other, mostly domestic sectors. In recent years, there have been no local extras (wage drift). This has been welcomed by the big trade unions as it is a way to control wage distribution. Chart 2. We expect inflation to fall, RB does not, the Riksbank, Danske Bank Chart 3. Wage expectations too high Wage growth slowed markedly in 2010 with the one-year so called crisis deal and has remained on this slower growth path ever since. One reason why trade unions have agreed to this may be that they have realised that inflation has been even slower, in essence still producing real wage growth. Current deals suggest wage growth will remain slow for another two years, laying the ground for a domestic inflation rate that is incompatible with the Riksbank s inflation target. Modest FX impact FX movements have on average not been an important determinant for inflation. That said, however, during periods of strong FX trends such as 2014-2015 where the trade-weighted Swedish krona, KIX, weakened sharply, this has actually been the prime inflation driver. This should not be surprising as this was a period when the Riksbank embarked on an unprecedented easing journey relative to other central banks. Once that divergence stopped, the currency stabilised and the impact on imported inflation gradually faded. At this time, we view the EUR-dominated KIX-index as neutral for inflation, while the weaker USD has a slightly depressing impact on import prices. China is the world s most important producer of consumer goods. As such, the level at which it exports its goods is key to global goods inflation. As we highlighted in the global inflation piece, China s export prices have dropped back into slight deflation after a short period of increases (Part 1: Global Inflation US stimulus and closing output gaps pose upside risk, 26 February). Currently, these goods are priced in USD and comprise clothing, furniture, electronics and petrol (see below). In this respect, USD/SEK movements are important for Swedish consumer import prices. For some other goods such as food, cars and electricity (see below), the EUR/SEK is more important. That said, the KIX-index works as a good proxy for the overall FX impact as these tend to co-move against the SEK. Inflation has become less sensitive to energy prices in recent years, despite tax hikes. However, energy prices high volatility means that they are still a significant factor to consider. The transmission from market prices to consumer prices is immediate. Swedish consumers are exposed to floating electricity prices to a high degree. Chart 4. The Phillips curve has broken down Chart 5. Low imported inflation CPI depends on the repo rate When looking at CPI instead of CPIF (for those trading linkers or with agreements based on CPI), mortgage rate changes are extremely important. In fact, for CPI interest-rate movements are more important than FX movements. Roughly 70% of mortgage loans are floating (i.e. 3m rates), which means that they are directly linked to the Riksbank s repo rate via the interbank market 3m Stibor. This means that future repo rate hikes will have a strong 2 28 February 2018 www.danskeresearch.com

impact on CPI inflation. We estimate that a 25bp rate hike from today s low levels (3m mortgage rates at 1.5%) would add about 0.4pp to CPI inflation. Hence, today s steep Swedish money market curves imply a very big impact on future inflation. It is questionable to what extent this is considered in market-based BEI inflation or in Prospera inflation expectations. One-off factors important in 2017 Many significant temporary price innovations are not fundamental inflation drivers but may still be very important for the inflation outlook. For instance, tax hikes or public charges may have a strong impact on inflation developments. But if they are not repeated, inflation will fall back. 2017 was such as year, as the Swedish Government raised petrol, electricity, alcohol and chemical taxes on electronics. Moreover, we saw a string of other unusual price increases throughout the spring of 2017 which are unlikely to be repeated to the same extent in 2018: Hotel prices soared in relation to the UEFA cup final, banks raised card charges sharply twice and electricity companies raised grid fees sharply. Some of these items will be repeated, but not to the same extent, which implies a negative base effect or that the inflation rate is set to fall. Chart 6. Service CPI has spiked but should align with service PPI Can domestic demand drive inflation higher? This is the old school way of thinking about inflation. One can question if the current increase in consumer income is strong enough to produce a demand shift that outstrips supply. At least goods, but probably also services prices, are increasingly transparent via price apps such as the domestic Pricerunner, Prisjakt or even the international Ali Express, Wish or Amazon. All these serve to increase competitiveness on a global scale, cutting prices, to the benefit of consumers. Norway: inflation on the rise Core inflation dropped to 1.1% y/y in January. Through monthly volatility in airfares, core inflation has hovered around 1.3% since August. Looking ahead, we expect core inflation to move to around 2% towards the end of the year on a combination of higher imported inflation and a gradual stabilisation of domestic inflation. Centralised wages, but a lot of local drift Historically, Norwegian wage determination has become known as a rather centralised system compared to most other European countries, including Denmark, though not compared to Sweden. This strong centralisation and coordination, i.e. wage settlements based on close cooperation between the central authorities and the labour market organisations, has been considered a main factor behind the favourable labour market situation that has characterised Norway during the recent 25 years. The main goal has been to preserve the competitiveness of Norwegian industries. This implies that the sectors exposed to foreign competition, mainly the manufacturing sector, open up the annual negotiations. The wage settlements result in a central adjustment of wages, but also include an estimate of the annual wage increase by including both the wage overhang (actual numbers) and the wage drift (estimate). This wage settlement works as a framework for the rest of the economy, including public sector agreements. There are a lot of local negotiations (at the company level) in most of the private sector, ensuring a solid contribution from wage drift to overall wage growth. Since 2006, the wage drift has contributed 2.3 times the effect from the central agreement. Especially, we note that in years where the labour market tightens, wage drift tend to contribute even more. The wage drift is a striking difference to Sweden, where wage growth has followed central agreements much more closely. In Denmark, the whole wage process is more decentralised. Chart 7. Core inflation has stabilised Table 3. Drift the most important part of wages 1) Estimate Source: TBU 3 28 February 2018 www.danskeresearch.com

Wage driven inflation in Norway In our view, the quarterly wage statistics have been signalling a pick-up in wage growth, suggesting the Phillips curve is very much alive in Norway, unlike in Sweden (see Chart 8). Wage drift allows market pressure to lead directly to higher wages at the company level in Norway, while Sweden adheres more to the result of the central negotiations. Since unemployment peaked in Q3 16, wage growth in Norway has risen from 1.6% to 2.5% y/y. Albeit extremely moderate, the improvement is not very far from what would have been expected based on the fall in unemployment in that period. Hence, as the labour market now tightens, we suspect wage growth could deliver an upside surprise at some point. The annual report from TBU ahead of the wage negotiations indicates that wage drift last year was a bit higher than anticipated, and overall wage growth ended at 2.5% in 2017. The wage overhang into this year is calculated at 1.1%, and we expect wage growth at 3.0% this year and 3.3% in 2019. There is a close relationship between wage growth and domestic inflation in Norway (see Chart 9). As expected, the recent structural drop in productivity growth has resulted in an even closer margin between those two factors. However, as we expect productivity growth gradually to turn, we think domestic inflation will improve more slowly than indicated by wage growth in isolation. That said, we estimate that domestic inflation bottomed out in 2017 at 1.6%, and will gradually move above 2% during 2018, approaching 2.5-3% during 2019, driven by higher wage growth. As domestic inflation accounts for roughly two thirds of core inflation, this will in isolation lift core inflation by 0.3pp by the end of the year and by 0.6-0.9pp by the end of next year. Exchange rate lift to inflation ahead For some years, there have been large fluctuations in Norwegian inflation prints. This reveals the importance of the exchange rate and imported inflation for the headline figures. Imported inflation accounts for roughly one third of core inflation, and the relationship between the exchange rate and imported inflation seems to be around 1 to 3. As a rule of thumb, we expect a 10% change in the (import-weighted) exchange rate to result in a 1% change in core inflation. The lag structure is not straight-forward, as various goods can have various delivery times, but we often reckon on a full implementation within 9 months. Hence, we expect the depreciation of the import-weighted NOK (I-44) from August through December last year to have increasingly upward effects on imported inflation, gradually pushing core inflation upwards. As illustrated in Chart 10, imported inflation should rise from the current level of 0.2-0.4% y/y to above 2% y/y in September-October, contributing to a 0.7pp lift in core inflation. However, if our expectations of a stronger NOK are confirmed, the effect will gradually weaken and turn negative towards the end of 2019. Downward pressure from rents to fade Rents account for roughly 20% of core inflation, the most important part of the service consumption basket as services excluding rents account for roughly 30%. Rents consist of both actual rents paid by renters, but also by imputed rents, a way to calculate living costs for residential owners. There has been a lot of criticism regarding rents in the CPI figures, as there occasionally seem to be counter-intuitive movements in these figures. Lower mortgage rates should reduce renting costs, but at the same time lower rates sometimes mean higher housing prices and hence higher rents, both actual and imputed. Basically, this translates to lower rent inflation when mortgage rates drop due to a recession, but the possible triggering of higher rent inflation if rates are cut without the real economy taking a hit, as seen in 2013. Chart 8. The Phillips curve still works in Norway Chart 9. Cost-push inflation (% y/y) Source: Norges Bank, Danske Bank Chart 10. Imported inflation set to rise Chart 11. Rents are about to turn 4 28 February 2018 www.danskeresearch.com

Since last winter, the turnaround in the housing market finally pushed rents in the CPI downwards. Based on the improving supply-demand balance, we expect housing prices are about to bottom out. Hence, the downward pressure on rents in the CPI will gradually fade into the second half of this year, and start to rise throughout 2019 supported by higher mortgage rates as Norges Bank starts the normalisation process. Energy prices are less important The energy components contribute roughly 6.5% to headline CPI, with fuel prices accounting for 2.5% and electricity (heating) for 4.0%. Due to the relatively high level of tariffs (60% of pump prices), the spill over to consumer inflation from the oil price is muted. The relationship between the oil price and petrol/diesel prices is roughly 1 to 3, and with a weight of 2.5% that implies that a 12% change in the oil price moves headline inflation by 0.1pp. Based on our oil price forecast, we expect fuel price inflation to rise from current 2% y/y towards 7-8% y/y by July. As almost all electricity is hydropower, the fluctuations in electricity prices are more dependent on the supply side (weather) than demand. Hence, the contributions to inflation from electricity prices can be both volatile and hard to predict. Over time, there seems to be a stronger upward trend in electricity prices than in core inflation. Since 2004, average headline inflation has been 1.97% whereas average core inflation (excluding energy) has been 1.67% Denmark: upside risk to inflation in 2019 Unlike in Sweden and Norway, inflation in Denmark is to a much greater extent tied to that of the euro area. This year, we expect Danish inflation somewhat below the euro area due to base effects from what is essentially random variation, and even though wage growth is slightly higher. We expect that the gap will close again in 2019. In this, we differ from the pricing in the inflation-linked bond market, which implies that Danish inflation will remain relatively low in 2019, at about 1.1%, against our call for 1.4%. In addition, in the mediumterm, we expect the history of minimal difference to continue, but with marginally lower numbers for Denmark. Current deviation is random variation Over the last 20 years, inflation in Denmark has followed the euro area closely, but with occasional short-term deviations. Such a deviation is also present in the latest data, for January, where CPI inflation in Denmark was 0.5pp below HICP inflation for the euro area. Sometimes differences are caused by large movements in oil products which have a lower weight in the Danish index. However, differences are also often driven by more or less random variation in the Danish sub-indices. We think that is the case now, but do not expect rates to re-converge before the end of 2018, as base effects from things like lower bridge tolls keep Danish inflation rates down. That does not mean that underlying inflation pressure is weaker in Denmark currently. Chart 12. Higher oil prices to lift fuel prices Chart 13.Temporary low inflation in Denmark It is not surprising that Danish inflation is closely linked to that of the euro area. Denmark s business cycle closely resembles that of the euro area, and monetary policy is in practice very similar as well. The strong credibility of the fixed exchange rate policy means that inflation expectations in Denmark are similar to those for the euro area. From a bottom-up perspective, 59.6% of Danish HICP is determined by either world market prices for food and energy, imports, or administratively determined prices, according to Nationalbank calculations. For CPI, the share is even higher, at 65.1%. Slightly higher wage growth Private sector wage growth is running at 1.9-2.2% y/y, depending on definition. Denmark has comprehensive labour market agreements as in the other Scandinavian countries, with 5 28 February 2018 www.danskeresearch.com

most of the private sector currently covered by agreements entered in 2017 and running for 3 years. The agreements usually state a minimum wage, but few are paid that, and most of the actual wage formation happens at the company level, which is different from Norway and especially from Sweden. As the labour market has tightened, we have seen wage growth increase slowly, and we expect that process to continue, given the growth outlook. Over the past 20 years, Danish wage growth has not been a useful factor for predicting deviations in inflation between Denmark and the euro area, and we do not expect that to change, given the small differences and the fact that such a small part of the CPI is determined by the domestic market-based economy. Danish inflation could be slightly below euro area in longer run Since 1997, inflation has on average been 1.8% in Denmark and 1.7% in the euro area. That difference can be explained by the fact that Denmark uses the national CPI definition while the euro area uses the harmonized HICP using that measure, Danish inflation has also been 1.7% (even with two decimals, the spread is only 0.01pp). The difference is that Danish CPI includes a rent for owner-occupied housing, which is assumed to develop in line with rents in rental housing. That pulls in the direction of higher CPI in periods of declining inflation, as rents are mostly regulated and linked to inflation the preceding year. Hence, as we enter a period of increasing inflation, the effect could be in the other direction. That creates a downside risk for Danish inflation relative to the euro area. In the same direction, GDP per capita is 16% higher in Denmark, implying a slightly lower inflation rate, all else being equal. Also, there may be a tendency for Danish retail margins to be more undermined by internet trade, as Danes do the third-most internet shopping in the EU, and as margins are probably higher than average to begin with. All in all, we see risk slightly to the downside on Danish CPI relative to euro area HICP in the long term.. Chart 14. Synchronised economies Chart 15. Danish wage growth on the high side Note: Statistics Denmark (DST) data is more comparable to the euro area, while DA data more closely reflects employer costs for similar employees Chart 16. Margins under pressure? 6 28 February 2018 www.danskeresearch.com

Disclosures This research report has been prepared by Danske Bank A/S ( Danske Bank ). The authors of this research report are Las Olsen, Chief Economist, Denmark, Michael Grahn, Chief Economist, Sweden, Frank Jullum, Chief Economist, Norway, and Thomas Harr, PhD, Global Head of FICC Research. 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. Danske Bank s research reports 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 as sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates None. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research report has been prepared by Danske Bank (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided herein. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. 7 28 February 2018 www.danskeresearch.com

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