Euroland: Inflation in Temporary Decline

• Euroland HICP inflation declined to -0.3% in September from -0.2% in August. This was 0.1% below Friday's consensus expectations.
• The impact of the crisis on wages and prices could be slightly bigger than previously expected. We project that core inflation will bottom at around 0.7% in spring 2010.
• Developments in oil prices and global food prices indicate that European food and energy price developments will be subdued for several months to come.
• We expect inflation to return to positive territory in November, driven upward by base effects. We project inflation at around 1.2 % in 2010.
• With less upside risks to inflation in the medium term the ECB will be less eager to hike rates. A first hike in September 2010 rather than June 2010 is a possibility.

Euroland HICP inflation declined to -0.3 % in September from -0.2 % in August. This was 0.1% below Friday's consensus expectations, but probably not a surprise to many following the negative surprises we already had received from e.g. Germany and Spain. We don't have a detailed breakdown, but it seems that the negative surprise is only partly to be explained by energy.

We are looking for signs that core inflation is showing extra softness. The impact of the crisis on wages and prices in Euroland could turn out to be slightly bigger than previously feared and this will then lead to a longer period of inflation well below ECB's target. Core inflation stood at 1.3 % in August and we expect that it has come down to 1.1 % in September. We project that core inflation will bottom at around 0.7 % in April or May 2010.

The oil price in both USD and EUR has been on a slightly declining trend since August. Global wheat and corn prices have also come down significantly since early June and are now at very low levels compared to the peak last year. Wheat prices are now at their lowest level since early 2006. Freight rates (Baltic Exchange Dry) have also declined steadily from a peak of USD 4290 in early June to USD 2192 on September 28. All in all these developments indicate that both food and energy price developments will be subdued for several months to come.

Nevertheless there are substantial base effects from the steep decline in energy prices last year and so we expect inflation to turn to positive in November at about 0.3% following a tick upward to -0.2 % in August. We currently project inflation around 0.3% this year and 1.2% in 2010.

With less upside risks to inflation in the medium term the ECB will be less eager to hike rates. More soft data on inflation and wages combined with a still very downbeat communication from the ECB indicate that a first hike in September 2010 (after the July 12-month long-term refinancing operation has matured and the markets are back from their summer holiday) is slowly becoming as likely as our current expectation of a first hike in June 2010.

Wages have already fallen sharply in the first half of 2010 and we now see that core inflation is becoming very soft too. A negative feedback loop could result in further declines in wage growth. Lower wage growth will make it more difficult to kick start private consumption in early 2010. We think that if this fails there is substantial risk that we will see a double-dip. A turn in the labour market is the key event that can spur private consumption in the current situation even if wage growth is low.

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

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