28 March 2017
Headline inflation in the Eurozone came in at a four-year high of 2% year on year (y/y) in February (see Chart 4). Monetary policy buffs will recognise that this represents an overshoot of the ECB’s policy target of ‘close to but below 2%’ inflation. Of course, there is considerable dispersion around this rate when we drill down to the member state level. France has not seen such significant increase in its headline inflation; the rate actually decelerated to 1.4% in February from 1.6% in January. However, conversely, the German inflation rate is even higher at a lofty 2.2% and a startling 3% in Spain. Do such highs spell the immediate withdrawal of monetary support and movement towards policy normalisation? The short answer is no. It is important to bear in mind Draghi’s comments in January that for the ECB’s Governing Council to take policy action, inflation needed to be durable, self-sustaining in the absence of monetary support, at target over a medium-term time horizon and broad-based.
Specifically, he noted that the Governing Council would look through inflation that seemed ‘transient’ and unlikely to affect medium-term price stability. This reaction function is important because the dramatic acceleration in the headline inflation figures of late can be attributed in a large part to energy price base effects, owing to the collapse and subsequent recovery of energy prices, rather than underlying inflation pressures. These base effects should begin to wash out of the numbers in the coming months. Indeed, we may have seen peak headline inflation in the Eurozone or at least are approaching it. Going forward, we expect headline inflation to move back down towards core inflation, which posted 0.9% in February. A useful illustration of this view is to use the current oil forecast curve to extrapolate the trajectory of inflation for 2017 and 2018. The curve currently reflects an average oil price in 2017 and 2018 of approximately 52$/barrel. Assuming a constant exchange rate at current levels, and our own forecasts for core inflation of 1.1% this year and 1.4% next year, the current oil price forecast curve leads headline inflation to average 1.7% in 2017 before falling back to 1.4% in 2018 (see Chart 5). Given that the current level is 2%, this suggests that there is little further upside through the rest of the year for the headline figure.
Ultimately, the outlook for monetary policy will depend on underlying inflation pressures, as Draghi has noted again and again. In terms of core inflation, the current 0.9% y/y rate is a far cry from the post-crisis high of 1.7% in July 2012 and nowhere near target rate. Wage pressures are a key factor in driving core inflation and, while they tend to be sticky and have shown modest growth in a number of member states, no urgent upward pressure appears to be on the horizon. Labour markets have tightened naturally through the recovery in a number of member states, a topic we have covered in this publication recently, but the feedthrough mechanism to wage pressures appears to be relatively weak even where spare capacity has been eroded, e.g. Germany. We do think core inflation will accelerate incrementally through 2017 to 1.1%, then 1.4% in 2018 and then 1.7% in 2019, although the risks to this forecast are to the downside. The strength of these underlying pressures will be important to not only the trigger for policy normalisation, but importantly, the pace of withdrawal through 2018 and 2019.
Stephanie Kelly, Political Economist