Part 2: Eurozone Inflation Upside risks from oil prices and rising wage pressures

Investment Research General Market Conditions 27 February 2018 Part 2: Eurozone Inflation Upside risks from oil prices and rising wage pressures In this second document in our series, we focus on eurozone inflation. Looking at different factors such as monetary and fiscal policy, the oil price and exchange rate impact as well as evidence on rising wage growth, we conclude that the balance of risks to our inflation forecast (1.4% and 1.3% in 2018 and 2019, respectively) and market pricing lies clearly on the upside, particularly in 2019. We expect the impact of monetary and fiscal policy on euro area inflation in 2018 and 2019 to be balanced: while euro area fiscal policy might become moderately more expansionary in 2019, we believe gradual ECB monetary policy normalisation will increasingly become a disinflationary factor. We see upside risks to our inflation forecast from the direct and indirect effects of higher oil price rises but we believe the stronger euro will increasingly act as a mitigating factor from H2 18 onwards. In light of the lack of a clear upward trend in super core inflation, we remain sceptical about a strong pickup in core inflation in the near term. This said, there are clear upside risks to core inflation, primarily in 2019, stemming from the strong growth momentum and early signs of rising wage pressures. Balance of risks to eurozone inflation lies on the upside As discussed in Part 1: Global Inflation US stimulus and closing output gaps pose upside risk, 26 February, many factors have recently contributed to renewing the market s belief that reflation has finally arrived. Higher oil prices and the strong euro area expansion together with signs of rising wage growth have fuelled similar beliefs in the eurozone. However, despite the increasingly favourable environment on the global front for reflationary forces to materialise, what is the evidence for the euro area, where inflation pressures remain very subdued and well below levels that would allow the ECB to raise interest rates anytime soon? Inflation and markets Part 1: Global Inflation, 26 February Part 2: Eurozone Inflation, 27 February Part 3: Scandi Inflation, 28 February Part 4: FI Implications, 1 March Part 5: FX Implications, 2 March Special issue on 27 February: The Remarkable Decline in Emerging Market inflation: Facts and investment implications Chart 1. Markets pricing inflation below our forecast in 2019 Markets are still pricing a very subdued outlook for euro area inflation over the next two years, with a profile that is for the most part below our relatively conservative inflation forecast, which is HICP inflation at on average 1.4% in 2018 and 1.3% in 2019 (see Chart 1). Table 1. The balance of risks to eurozone inflation lies on the upside, especially for 2019 2018 2019 Global forces Moderate Upside Upside Source: Eurostat, Macrobond Financial, Danske Bank Euro zone fiscal/monetary policy Balanced Balanced Oil price rise Upside Upside EUR appreciation Balanced Downside Wage growth Moderate Upside Upside Total Moderate Upside Upside Source: Danske Bank Analyst Aila Mihr +45 45 12 85 35 amih@danskebank.dk Assistant Analyst Christian Belling Sørensen chsr@danskebank.dk Important disclosures and certifications are contained from page 7 of this report. www.danskeresearch.com

Looking at different factors such as monetary and fiscal policy, the oil price and exchange rate impacts as well as evidence on rising wage growth in more detail below, we think the balance of risks to our inflation forecast clearly lies on the upside in the magnitude of approximately 0.2-0.4pp, particularly in 2019 on the back of rising wage pressures (see Table 1). Such a higher profile would be in line with the ECB s current inflation forecast, which expects HICP inflation to be 1.5% in 2019 and 1.7% in 2020. This said, it remains uncertain whether, and to what degree, the above-mentioned factors will materialise. Hence, we stick to our original inflation forecast for now. However, we stress that we see upside potential for inflation market pricing, especially for the low levels in 2019. Muted inflation impact of fiscal and monetary policies We expect fiscal policy in the eurozone to be only moderately expansionary in 2019, with limited impact on inflation. Despite the new German government s plan to increase infrastructure spending and lower social security contributions, the overall fiscal loosening is modest in size (EUR46bn) and spread out over 2018-21, meaning the overall fiscal stance in Germany will remain relatively neutral (for details, see also Part 1: Global Inflation US stimulus and closing output gaps pose upside risk, 26 February). Irrespective of its composition, the new Italian government is likely to pursue a moderately expansionary fiscal policy, as all parties are calling for higher public spending. However, actual policies may be more moderate than envisaged, given the tight surveillance that Italy is under visà-vis the European Commission due to its high debt ratio. Different measures of the monetary policy stance in the euro area point to somewhat mixed evidence (see charts 2 and 3) but with the ECB starting to embark on a gradual path of policy normalisation, we expect less accommodative monetary conditions in the euro area in 2018 and 2019. Excess liquidity is likely to remain sizable in the near term as long as the ECB continues its QE reinvestments but, despite the strong balance sheet expansion since the advent of QE in 2015, broad and narrow money supply growth remained fairly stable and at a below pre-crisis level (see Chart 4). This disconnect is reflected in the decline in the money multiplier possibly due to regulatory changes to banks capital and liquidity reserves limiting the effectiveness of the monetary transmission mechanism. Chart 4: Money supply growth remains flat in light of declining multiplier Source: ECB, Macrobond Financial, Danske Bank Chart 2: Nominal GDP growth relative to the ECB policy rate points to less expansionary ECB policy since 2016 Chart 3: Difference between the natural and real policy rate points to more accommodative ECB policy Source Macrobond Financial, Danske Bank Source: OECD, Macrobond Financial, Danske Bank Overall, we expect the effect of monetary and fiscal policy on euro area inflation in 2018 and 2019 to be balanced: while euro area fiscal policy might become moderately more expansionary in 2019, we believe gradual ECB monetary policy normalisation will increasingly become a disinflationary factor. 2 26 February 2018 www.danskeresearch.com

Upside risks from continued oil price rises but euro appreciation set to become a mitigating factor Oil prices in USD terms have risen sharply since mid-2017 but the impact on inflation in the euro area has been mitigated partly by a similar steep rise in the EUR/USD exchange rate. In euro terms, oil prices have risen by 7.6% on average in 2017 and via the direct effect on the energy component of HICP will lift euro area headline inflation in coming months. Apart from the direct effect on energy price inflation, oil prices also affect other HICP components via production costs. Core inflation items such as services related to transport, package tours and non-durable goods that are produced with high energyintensity will also be lifted by higher oil and producer prices in 2018 (see Chart 5), although the effects take some time to feed through. This said, oil or oil-related input costs are only one factor in firms pricing decisions and strategic considerations vis-à-vis competitors and the cyclical position of the economy may also play an important role in determining the degree of indirect effects of oil price rises showing up in core inflation. Chart 5: Core inflation items supported by higher oil price Source: Eurostat, Macrobond Financial, Danske Bank Chart 6: Energy price impact set to moderate in 2019 due to base effects According to an ECB study, a 7.6% increase in oil prices in euro terms would give rise to a 0.3pp increase via direct effects on the energy component most of which would happen relatively quickly and an approximate 0.15pp increase via other HICP components over a period of up to three years. However, even when assuming continued steep oil price increases compared with our base scenario (Brent oil at USD63/bl in 2018 and USD65/bl in 2019), the impact on the inflation profile would decline from mid-2018 onwards due to base effects (see Chart 6). Hence, to create a lasting impact on the inflation profile, it is important that higher oil prices also affect inflation expectations and the wage formation process (i.e. so-called second-round effects materialise see Chart 7). The actual impact of the direct and indirect effects of oil price rises on euro area inflation may be blurred by the offsetting effect of the continuing euro appreciation. A stronger EUR/USD exchange rate not only mitigates oil price increases in euro terms but ceteris paribus also creates upward pressure on the effective euro exchange rate (EER-38) and thereby lowers import prices. This spills over to lower prices for non-energy industrial goods (see Chart 8). Assuming an unchanged effective euro for the rest of 2018, we obtain an annual appreciation of the effective euro exchange rate of around 4.1% (see Chart 9). Using elasticities from the OECD s new global model, the 4% stronger effective euro would drag down headline inflation by around 0.1pp after one year and an accumulated 0.3pp after two years. Note: Assumptions: EUR/USD at 1.22 in 2018 and 1.29 in 2019, Brent oil at USD90/bl end- 2018 and USD100/bl end-2019 Source: Eurostat, Macrobond Financial, Danske Bank Chart 7: Oil price rise needs to give rise to second-round effects to have lasting impact First-round effects Oil price (in EUR) Direct effects Indirect effects Producer prices Chart 9: Strong depreciation in effective EUR over 2015 Chart 10: should moderate EUR appreciation impact on inflation in 2018 Second-round effects HICP inflation 0.4 pp 0.3 0.2 0.1 0.0-0.1-0.2-0.3-0.4-0.5 Impact on inflationfrom currency moves (The effective euro is assumed unchanged at current level) 2017 2018 2019 2020 Effect of changes until 2014 Effect of depreciation in 2015 Effect of appreciation in 2016 Effect of appreciation in 2017 Effect of appreciation in 2018 Aggregate effect on inflation Inflation expectations Source: ECB, Danske Bank Wages Chart 8: NEIG inflation negatively impacted by EUR appreciation Source Macrobond Financial, Danske Bank Source: OECD, Macrobond Financial, Danske Bank Source: Eurostat, Macrobond Financial, Danske Bank 3 26 February 2018 www.danskeresearch.com

However, quantifying the exact pass-through to HICP inflation is difficult, as changes in the exchange rate take about two years to pass through fully to inflation and at any point in time the net effect is always a combination of lagged effects of past exchange rate movements. Therefore, the total exchange rate effect on inflation in 2018 will still be fairly modest, as the euro appreciation in 2016-17 is counterweighted by the effect of the large euro depreciation in 2015. The full impact will hence become mainly apparent in 2019 and could lower headline inflation by up to 0.4pp (see Chart 10). We think the actual degree of exchange rate pass through might be lower as implied by the model above due to a range of factors, including: (1) upward pressure on producer prices of euro area trading partners due to oil; (2) growing currency invoicing of extra-euro imports in euro; (3) a stable inflation environment, which makes firms more reluctant to adjust prices to transitory exchange rate shocks; (4) part of the rise in EUR/USD has also been driven by the weaker USD leg and (5) the stronger exchange rate is at least partly also a reflection of stronger domestic demand. Chart 11: Market inflation expectations have recovered Source: Bloomberg, Macrobond Financial, Danske Bank Chart 12: Trend productivity growth has declined As we see risks to our current oil price forecasts mainly on the upside, we conclude that there are also upside risks to our inflation forecast from the direct and indirect effect of oil price rises but, in our view, the stronger euro will increasingly act as a mitigating factor from H2 18 onwards. Ambiguous outlook on higher euro area wage growth and core inflation In line with the rise in oil prices, we have observed an increase in market inflation expectations from the trough in July 2017 (see Chart 11), likely reflecting growing market confidence in second-round effects materialising due to the continued strong global and euro area economic momentum. However, wage growth is still the missing link for higher underlying inflation pressures in the euro area and evidence for higher wage growth remains ambiguous. Although the fall in unemployment has continued to be stronger, as suggested by the pace of economic expansion, wage growth has remained contained, probably due to lower trend labour productivity growth (see Chart 12) and remaining slack in the labour market when looking at broader unemployment measures, especially in periphery countries. Nevertheless, as unemployment is slowly closing in on NAIRU, early signs are emerging that wage growth is gradually picking up from the low levels of 2013-16 (see Chart 13). Consumer price expectations have reached the highest level since 2013 and increasing capacity constraints and labour shortages should exert a positive impact on negotiated wages (see Chart 14). The current strong growth momentum in the euro area is further raising the odds of secondround effects materialising. However, so far, underlying inflation measures such as supercore inflation, which includes only HICP items with a statistically significant and positive link to movements in the output gap, do not yet point to a turning point in the underlying inflation pressures. Historically, super core has reacted to movements in the output gap with around a six-month lag. However, this link has weakened since 2015 (see Chart 15), potentially due to a shrinking number of HICP items that react to the output gap, as the ECB also recently noted. In light of the lack of a clear upward trend in super core, we remain sceptical though about a strong pickup in core inflation in 2018. Source ECB, Macrobond Financial, Danske Bank Chart 13: Wage growth has started to pick-up Source: Macrobond Financial, Danske Bank Chart 14: supported by increasing labour shortages Source: Macrobond Financial, Danske Bank 4 26 February 2018 www.danskeresearch.com

This said, the balance of risk for core inflation due to the strong growth momentum clearly lies on the upside. Assuming that GDP growth in 2018 remains at similarly high levels as in 2017 (for illustration we assume here 2.5% in 2018 and 2.3% in 2019 versus our baseline of 2.0% and 1.8% in 2018 and 2019, respectively), Okun s Law, which links developments in unemployment to GDP growth, points to continued employment gains (see Chart 16). Using the predicted unemployment values, the current shape of the Phillips curve would imply core inflation of around 1.7% by the end of 2018 and 1.8% by end-2019 (see Chart 17). Chart 15: Super core inflation shows no clear upward trend yet Chart 16: Continued strong growth and employment gains Chart 17: raise upside risks to core inflation Source: ECB, Macrobond Financial, Danske Bank Source Eurostat, Macrobond Financial, Danske Bank Source Eurostat, Macrobond Financial, Danske Bank Chart 18: Higher IG Metall wage settlement in 2018/19 IG Metall wage negotiations: limited upside risks for German core inflation in 2019 What is the evidence so far that second-round effects have started materialising, looking at the example of the recently concluded German IG Metall wage negotiations? With a lifespan of 27 months, we estimate that the IG Metall agreement equates to around 3.5% wage growth for metal and electro workers in 2018 and 3.3% in 2019. Although this is higher than wage settlements in recent years, it is also not unusually high from an historical perspective (see Chart 18). What does the IG Metall settlement mean for overall wage growth in the euro area s biggest economy and will it ultimately help the ECB to achieve its inflation target? At least on the latter, we remain sceptical. The IG Metall settlement affects around 3.9m workers in the German metal and electro industry, which constitutes only around 9% of the total German labour force, so the impact on negotiated wages in the whole economy will depend on spillover effects on other sectors of the economy. Early signs of this are already emerging, with a similar union demand of 6% wage increase for 12 months in the upcoming public sector bargaining round (affecting some 2.5m workers). IG Metall wage agreements have historically been a good predictor of aggregate German negotiated wages one year head. A simple regression model points to negotiated wage increases of 1.6% in 2018 and 2.4% in 2019, which is still below previous peaks (see Chart 19). However, what ultimately matters for inflation is wage increases relative to productivity growth (i.e. unit labour costs) and unless wage growth accelerates beyond productivity growth in a sustained manner, we expect inflation rates to remain low. Assuming unchanged labour productivity growth of 1.3% in 2018 and 2019, our negotiated wages forecast points to unit labour costs growth still well below the ECB s 2% target (see Chart 20). Given the close link between unit labour costs and core inflation (see Chart 21), this leaves us to conclude that the IG Metall wage settlement in isolation points to only limited upward pressure core inflation in 2019. Source: IG Metall, Danske Bank Chart 19: IG Metall agreement points to only moderately higher negotiated wages Source: Eurostat, Bundesbank, Macrobond Financial, Danske Bank Chart 20: Unit labour costs growth to remain below ECB s target Source Eurostat, Bundesbank, Macrobond Financial, Danske Bank 5 26 February 2018 www.danskeresearch.com

Another dampening factor is that collective bargaining agreements cover only 45% of employees in Germany and negotiated wage increases in recent years have already been relatively high in light of low inflation and labour productivity. Therefore, it is important that higher negotiated wages spill over to sectors not covered by collective bargaining as well. The new German government s plan to reduce the number of temporary contracts could become a supporting factor for this spillover to materialise. Furthermore, the government is also planning to return to parity in the financing of contributions to the German statutory health insurance. This would act as an increase to employers social security contributions and thereby exert upward pressure on wage growth. Chart 21: Close link between unit labour cost and core inflation Chart 22: New jobs increasingly filled by Eastern Europeans Chart 23: Germany already has a high labour force participation Source: Eurostat, Bundesbank, Macrobond Financial, Danske Bank 32% Share of increase in German employment from 2013-2016 11% 6% 4% 4% 2% Total Eastern European Romania Poland Croatia Bulgaria Hungary Source: Destatis, BAMF, Macrobond Financial, Danske Bank Source: OECD, Macrobond Financial, Danske Bank Previously, net immigration from other EU countries has been a dampening factor on German wage growth. From 2013-16, almost one-third of jobs created in Germany were filled by Eastern Europeans (see Chart 22). However, we expect this trend to reverse as a marked acceleration in domestic wage growth in Eastern European countries is reducing incentives to seek employment in Western Europe. Given that Germany s labour force participation is already quite high compared with the European average and is unlikely to increase much further (see Chart 23), we expect issues of labour shortages to become only more pronounced in the future, strengthening employees bargaining position. Overall, in isolation, we see only limited upside potential from the IG Metall settlement on German core inflation in 2019. A significant rise in core inflation remains dependent on whether successive wage rounds in other sectors can replicate similar higher wage settlements. However, increasing issues on labour shortages and plans by the new German government to reduce the number of temporary contracts and increase employers social security contributions raise the prospect that we will see higher wage growth in Germany in 2019. 6 26 February 2018 www.danskeresearch.com

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