German Inflation Eases, Euro Exchange Rates Lose Altitude

  • German inflation falls faster than expected
  • Suggests peak could be in
  • Coincides with a weaker EUR
  • But economists warn inflation to remain stubborn
  • ECB still has further work to do

German inflation

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Euro exchange rates were lower on the same day data from Germany revealed a sharp decline in inflation which hints that prices in the Eurozone might come down faster than the European Central Bank currently anticipates.

Germany's most populous state - North Rhine-Westphalia - set the tone when releasing data that showed headline CPI dropped 1.0% month-on-month in December, the biggest decrease ever recorded.

This took the region's headline CPI inflation down to 8.7% year-on-year.

The all-Germany figure came out later in the day with a headline 8.6% year-on-year increase to December, below expectations for 9.1% and a material decline from 10% previously.

The month-on-month decline stood at -0.8%, nearly tripling an expected -0.3% reading and accelerating on -0.5% reported in November.

"Lower-than-expected energy prices due to the warm winter weather could, if they remain at current levels, push down headline inflation faster than recent forecasts suggest," says Carsten Brzeski, Global Head of Macro at ING Bank.

In the wake of the data the Euro was softer by 0.6% against the Pound and a percent against the Dollar.

"The big drop in Euro on weaker-than-expected German inflation data shows how much ECB hawkishness has boosted EUR/$. We are detecting the same slowing in inflation momentum in the Euro zone that we detected for the US back in July. The peak of ECB hawkishness is behind us," says Robin Brooks, Chief Economist at the IIF.



It would be difficult to lay all of the Euro's weakness squarely at the feet of the inflation numbers given the strong bid for the Dollar at the start of 2023, but the figures could have a bearing on the currency's performance.

The European Central Bank (ECB) surprised markets by signalling in December it will continue to raise interest rates owing to elevated Eurozone inflation rates, forcing markets to lift their expectations for the peak in Eurozone interest rates.

The signal has been credited by analysts as being supportive of the Euro.

Therefore, the Euro could come under pressure should incoming data prompt investors to bring expectations for the peak in Eurozone interest rates back down again.

"For the ECB, today’s drop in German headline inflation is another reminder that an energy price shock can actually turn around almost as quickly as it has emerged," says Brzeski.

The EUR to GBP exchange rate is now at 0.88, giving a GBP to EUR conversion of 1.1360. The EUR to USD rate is at 1.0560, giving a USD to EUR conversion of 0.9466.

In December the ECB warned inflation was unacceptably elevated and economists at the central bank forecast inflation will remain high in the short run but fall to 3.6% by the end of 2023.

"At least based on current energy prices, headline inflation in the entire eurozone could come down faster than the ECB had forecast in December," says Brzeski.

However, the ING economist warns that it could be too soon to sound the all-clear on the Eurozone's inflation problem.

"Past experience of energy price shocks has also shown that headline inflation can come down quickly, while core inflation remains stubbornly high and can even continue to increase. Therefore, today’s inflation numbers are not a relief, yet, only a reminder that eurozone inflation is still mainly an energy price phenomenon. The ECB cannot and will not base its policy decisions on highly volatile energy prices," says Brzeski.

The Euro will now look towards Friday's release of Eurozone inflation for a clearer sense of how prices are evolving across the region.

Looking at the details of Tuesday's numbers, German core inflation - which excludes energy and food - rose further from 5.0% to an estimated 5.1%.

Indeed, much of the decline in the headline rate owes itself to the govermnent making monthly payments for gas for many citizens in December.

"Germans will continue to suffer from high inflation for a long time due to the ECB's slow approach, even if the gas and electricity price brakes should depress inflation this year," says Jörg Krämer, Chief Economist at Commerzbank.

In fact, Commerzbank warns inflation will likely rise again in January because the government will not once again take over the payments for gas and district heating.

"However, inflation is unlikely to return to double digits. This is because the statisticians will take the electricity and gas price brakes into account in the price statistics from January," says Krämer.

Commerzbank warns price increases are likely to remain stubbornly high this year.

"Not least because of the ECB's slow action, German inflation expectations for the next five years have now risen to 5.0% (median) according to surveys by the Bundesbank. In an environment of de-anchored inflation expectations, trade unions are likely to be able to push through significantly higher wage increases and companies higher sales prices more easily," says Krämer.

Although inflation might have peaked, it could prove premature to herald a sharp decline.

The ECB will therefore likely not be swayed be a one-off decline that proves larger than anticipated, suggesting this month's data releases won't be a game-changer for the Euro.

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