Euroland: Core Inflation Contained but Not for Long

• The ECB seems willing to accept growth clearly below trend in order to defend its credibility. Referring to the upwardly revised staff projections of inflation reflecting mainly oil and food prices, but also the rising inflationary pressures in the services sector, it indicated very strongly that rates will be increased at the next meeting in July despite clear signs of a cooling Euroland economy.
• In this research we look at the development in and determinants of core inflation, which are central to the ECB. Contrary to the ECB we cannot identify any second-round effects in service CPI as a whole. We conclude that core inflation is likely to remain moderate until late summer, but will increase sharply during autumn as increases in goods prices eventually leave their mark on service prices.
• If Brent oil stabilises around USD 130/barrel, total inflation is forecast to remain around the current level until November. By then base effects will begin to have a marked effect, which will more than offset the rise in core inflation. If we assume a gradual decline in oil prices to USD 125 /barrel, headline inflation will fall below 2.0% by autumn 2009.

Core inflation contained so far

May inflation number cements July hike

Harmonised consumer prices rose 3.7% in May compared to 3.3% in April. Inflation in May was at the highest level since June 1992 and up 0.1%- point relative to flash. The steep increase in oil and food prices is the main driver behind the current high inflation rates. Core inflation increased slightly in May. Excluding energy, food, alcohol and tobacco inflation rose 1.7%, up 0.1%-point relative to April. Also, using the broader ECB definition (total ex energy and unprocessed food prices) core inflation edged up from 2.4% in April to 2.5% in May. These figures are cementing expectations of an ECB rate hike in July.

High inflation is not widespread at the moment

At the press conference in June ECB mentioned that signs of high inflation had become more widespread. In the Introductory Statement it referred to the upwardly revised staff projections reflect ing mainly oil and food prices, but also increasing inflationary pressures in the services sector.

A closer look at the price statistics reveals that year-on-year inflation was unchanged or lower in April than in March for all components but housing (which does include e.g. heating and therefore partially reflects developments in energy prices) included in the narrow core inflation index. In May year-on-year inflation rates have picked up relative to April in some services while declining in others. The pick-up in transport prices is related to the increasing energy prices. However, these movements may partly be the result of the early Easter this year, which makes it hard to draw any clear conclusions. Consequently, we do not think this single piece of evidence will influence ECB's rate decision in any significant way.

It may be more informative to look at developments on a slightly longer time horizon. From February to May we have seen year-on-year price increases in energy and food prices accelerate. At the same time inflation rates in most service sectors have been fairly stable. The notable exceptions have been housing and transportation, which both include some energy items.

On balance it seems fair to conclude that service sector inflation figures so far do not seem to indicate that high inflation has become more widespread in recent months. Thus, contrary to the ECB, we cannot identify any second-round effects in service CPI as a whole.

Core inflation will spike later this year due to past increases in food and energy prices

The crucial variables in the ECB rate decision equation are future developments in core inflation, wages and ultimately inflation expectations.

We expect core inflation to remain moderate until the late summer, but to increase rather sharply during autumn as past increases in goods prices leave their mark on service prices.

However, the process will be moderated as wage demand pressure is curbed by a rise in unemployment. Most likely the ECB will speed up this part of the process somewhat by hiking rates in July as strongly signalled at the June press conference.

The ECB is well aware of this development and even minor deviations in core inflation from this path should not play a major role in its rate decision. However, it cannot be ruled out that the ECB Council will interpret the development in core inflation in a rather hawkish way. Also, if projections indicate that core inflation remains elevated for a longer period, this could result in the ECB taking further action as it would most likely affect ECB's credibility.

ECB's credibility intact

Expectations regarding inflation this year and the next have risen. This is no surprise as short-run inflation expectations are usually closely connected to the current inflation rates.

So far these elevated short-run inflation expectations do not pose a serious risk to price stability and thereby ECB's credibility. But if expectations remain elevated it could have an impact on wage setting and thus feed into the price setting process, endangering ECB's credibility in the process.

Until now however, long-run inflation expectations have remained low and are currently below 2%. Thus ECB is expected to be able to anchor inflation and fulfil its mandate. In short, ECB's credibility is intact.

Financial market indicators of inflation expectations have risen. These indicators are based on the difference between government bond yields and similar inflation-indexed bonds. Movements in these differences do not only reflect inflation expectations but also developments in liquidity and inflation risk premiums. Therefore interpretation is not straightforward in the current situation, where the financial turmoil is having an effect on these differences.

Implicit expected inflation rates have moved up since the start of the financial crisis and in recent months they have increased further. The increases reflect higher inflation expectations as well as higher risk premiums.

Following ECB's announcement of a possible rate hike in July implicit inflation rates have decreased on the longer horizon, which indicates stronger credibility of ECB's inflation anchoring.

Danske Bank
http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst 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 no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets' research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.