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Is Inflation Back in the Eurozone?

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Is Inflation Back in the Eurozone?

The year 2017 is likely to mark the return of inflation to Europe. The combination of higher oil prices and the appreciation of the dollar against both the euro and the pound are already pushing headline inflation higher on the Old Continent. The annual Consumer Price Index (CPI) for the eurozone surged to 1.1% in December, the highest level since 2013. Eurozone inflation was lackluster between 2014 and 2016, ranging between 0.0% and 0.4%. In the next few months, it's likely to move higher and peak in the first quarter of 2017 around 1.5%, driven by energy base effects. Looking forward, we expect headline inflation to stabilize, as core inflation is unlikely to rise meaningfully above 1%.

Overview

  • We expect eurozone inflation to peak in the first quarter of 2017 around 1.5%, driven by energy base effects. Core inflation is unlikely to rise meaningfully above 1%.
  • Soaring eurozone inflation puts the ECB in a difficult position, as it needs to appease calls for higher interest rates by more hawkish policymakers while making sure to prevent any unwarranted tightening in financial conditions.
  • The ECB's monetary policy is likely to remain accommodative until core inflation experiences a sustained adjustment of its path, probably not before 2018.

In one year, the price of Brent crude oil jumped 40%, to $54 a barrel in December 2016 from $38 the previous December. The rise reached 45% in euro terms and close to 70% in pound terms as the dollar gained 3% and 20% against the respective currencies (see chart 1). The longstanding negative correlation between oil prices and the U.S. exchange rate has been reversed since spring 2016, when both the greenback and oil started rising in concert.

Crude oil prices seem to have primarily responded to their own supply-demand fundamentals, rather than follow the dollar's move. After OPEC concluded a comprehensive agreement among major producers to cut output by 1.6 million barrels a day at its meeting in Vienna at the end of November, prices of Brent on the spot market gained $10 over one month. However, downside risks for prices remain: demand remains weak while the promised cuts may not materialize in full. At the same time, market expectations for a stronger U.S. economy and a tightening in U.S. monetary policy are driving up the U.S. dollar. Following Mr. Donald Trump's victory in the U.S. presidential elections, markets have priced in higher growth and inflation in the country following promises of looser fiscal policies in the shape of tax cuts and greater infrastructure spending. This has driven a steepening of the U.S. yield curve, and with it a strengthening of the U.S. dollar. Assuming the economy continues to grow at a moderate pace, we expect the U.S. Federal Reserve to raise rates two more times next year and three times in 2018. If central bankers see signs of surging growth, and with it, a pickup in prices, they would likely up the ante and hike the benchmark federal funds rate even further.

The German rise in inflation looks more broad based

The recent rise in inflation has varied considerably across the eurozone. Germany and Spain led the expansion, with annual CPI estimates reaching 1.7% and 1.5%, respectively, and leaving the headline rate at its highest level since mid-2013. Italian inflation was up to 0.5% from 0.1% on previous month, while French price pressures picked up only marginally by 10 basis points (bps) to 0.6%. While the main contributor to the rise for all economies across the board was higher energy inflation, there are signs that core inflation nudged up, but probably only in Germany, where the labor market is tightening. Indeed, the rise in inflation in Germany looks more broad-based than for the eurozone, with sizable increases in inflation rates for food and services, in addition to energy. The German labor market continued its positive performance in 2016. The number of vacancies rose by 11% in one year to a record 687,000 people as of December 2016, while the unemployment rate declined to 4.1% in October last year, the lowest since reunification. In the rest of the eurozone, labor conditions are still more deflationary than inflationary, with the unemployment rate still at a high 9.8% as of November 2016.

Eurozone bond yields rose on the news of higher inflation reports, with the German 10-year Bund rising 8 basis points on the day, and the French yield by 12 bps. European bond yields have been moving up from their historical lows since October 2016 on the back of expected inflation rises. The upward trend has been reinforced after Mr. Trump's electoral win in November (see chart 2). The contagion from the other side of the Atlantic has only been partial, however. After initially tracking higher in line with U.S. trends, long-term European sovereign bond rates fell across the board, partially erasing some of the increase, while U.S. long-term interest rates stabilized at a relatively high level.

Soaring eurozone inflation puts the ECB in a difficult position

We think that the still very accommodative monetary policy from the European Central Bank (ECB) is capping the rise in long-term interest rates and therefore protecting the European Monetary Union from too much of a tightening in financial conditions. The ECB announced on Dec. 8 that it plans to scale back the pace of quantitative easing purchases to €60 billion per month from April 2017, but extend the program until at least December 2017. However, the surge in December inflation, although widely expected, puts the ECB in a difficult position. On the one hand, it has to appease calls for higher interest rates by more hawkish policymakers and by politicians of, in particular, the eurozone's strongest economy. On the other hand, the bank has to reassure investors that it won't consider any premature tapering, which could lead to an unwarranted further tightening of financial conditions, especially with so much political and policy uncertainty on the horizon. Indeed, global economic policy uncertainty is at an all-time high (see chart 3).

In our view, the ECB is likely to stay dovish for a long time, despite the increase in price pressures. With core inflation remaining subdued, the ECB could choose to look through the rise in energy inflation as "temporary." Monetary policy is likely to remain accommodative until core inflation experiences a sustained adjustment of its path, probably not before 2018.