Euro area core inflation: Under the surface

With political risks behind us and growth accelerating, the focus is shifting toward the removal of the ECB’s stimulus.

Political risks have decreased materially beyond the short term, in our view, and economic recovery is gaining pace. Growth is on track to reach our above-consensus GDP growth forecast of 2.2% in 2017. And with composite PMI near the levels historically consistent with tightening of the monetary policy, the focus is shifting toward the timing and pace of the withdrawal of the ECB’s extraordinary stimulus. Draghi’s recent speech at the ECB Forum on Central Banking in Sintra was a confirmation of that, with Draghi proclaiming that “the threat of deflation is gone and reflationary forces are at play”.

The pace of asset purchases might be affected by growth… Draghi suggested in his speech that the dosage of QE might be determined by stronger growth, even if inflation doesn’t pick up convincingly yet: “As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments – not in order to tighten the policy stance, but to keep it broadly unchanged”. This fits with our expectation for further incremental shifts in language over the summer and an announcement in either the September or October meeting that monthly asset purchases will be reduced to €40bn from January 2018, before being gradually wound down in Q3 of 2018.

…but underlying inflation remains the key determinant of the ECB policy. Draghi reiterated that asset purchases will continue until we see evidence of a sustained and durable convergence of inflation toward target.

Core inflation surprised on the upside in recent months and broke out of the tight range it held since mid-2013. Core inflation has averaged 1.2% in the four months to July, significantly higher than the average of 0.8% over the past few years. Three out of the last four core inflation prints were higher than consensus. And importantly, we believe that this increase is not erratic. We expect core inflation to remain near the current levels for the remainder of the year, although the scope for further rises is limited.

Domestic factors are currently an important drag on underlying inflation, while external factors likely became a tailwind in early 2017, we believe. A recent ECB article decomposed the deviation of euro area headline inflation from its long-run mean into contributions made by domestic and global shocks. Domestic factors correspond to wage and price-setting behavior, which is closely related to the domestic business cycle. Global factors capture the developments in commodity prices and exchange rates. The article found that both domestic and global shocks have played a key role in explaining disinflation since 2013, although the latter seems to have largely faded away (Figure 3).

Importantly, domestic factors appear to be the sole factor pulling euro area inflation down at the present and external drags have likely become tailwinds in early 2017 – as witnessed by the energy-driven spike in headline inflation in Q1 and a more recent rise in transport services inflation, we believe.

Veronika Roharova – Equity Research – Credit Suisse