Euroland: Headline Inflation Lowering While Core Picks Up
Final Euroland HICP for August confirmed the flash estimate of a 3.8% increase in consumer prices on a yearly basis. We think it is safe to conclude that this marks the beginning of a period of gradually declining inflation rates and that inflation peaked in June and July at 4.0% y/y.
On first glance, today's inflation figures did contain a small surprise as core inflation (i.e. total ex energy, food, alcohol and tobacco) rose by 1.9%, up 0.2 percentage points relative to July. According to our models the gradual pick-up in core inflation should have started one month later. Using the ECB definition of core inflation (total ex energy and unprocessed food prices), prices grew by 2.6% y/y which is 0.1 percentage points more than in July.
The detailed numbers reveal no strong signs of a significant pick-up in overall underlying inflation. Approximately half of the increase in core inflation from July to August was due to temporary volatility as summer sales were brought forward (probably as retailers responded to disappointing sales). In June year-on-year price increases on clothing were down 0.5%. In August prices increased 0.4% y/y. Higher prices on hotels and restaurants and leisure and communication also contributed to rising core inflation. However, this is more in line with our general expectation of a pick-up in core inflation on the back of past increases in food and energy prices (see Research - Euroland: Core inflation contained, but not for long). Although at a still somewhat elevated level, inflation rates for housing and transportation price increases are heading down as both include some energy items. On balance therefore it seems fair to assume that that second-round effects have still not materialised on a broad base. The pick-up in hotels and restaurant price increases is noteworthy as members of the ECB Council did refer to this specific sub index before the rate hike in July.
Energy and food price inflation remained at a relatively high level in August despite falling slightly on a monthly basis. Thus they continue to lift headline inflation on a year-on-year basis but the contribution is fading. Looking forward both the recent decline in especially oil prices and the effect from base effects which begin to kick in will drag down headline inflation. This of course depends crucially on developments in the oil price. In face of the current financial market turmoil, oil prices are highly volatile at the moment and we may see lower oil prices than we assume in our current inflation projection (of around USD 120 a barrel). We expect the effect on headline inflation from the above-mentioned gradual pick-up in core inflation to be more than offset by the assumed declining contribution from food and energy prices.
Market reaction was limited. Markets are mainly focused on developments in the financial market situation. We think the ECB's next move is likely to be a policy rate cut and we think it most likely that rates will be cut by 25bp in both March and June 2009. At that time, the economy will have looked weak for quite a while and headline inflation should have decreased markedly spurring a drop in household's inflation expectations. The precise timing of such rate cuts is tricky, and the current financial turmoil does add an element of uncertainty. Also the sharp decline in oil prices could make the ECB less reluctant to cut rates. Thus a rate cut might be on the agenda before March 2009.
Danske Bank
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