Eurozone Inflation Forecast to Rise Sharply but Won't Stop ECB Introducing Fresh Stimulus

Prices in the euro-area rose in June, according to data from Eurostat, released on Thursday June 30.

The flash estimate for Eurozone consumer price inflation showed a 0.1% rise in overall inflation, which was higher than the 0.0% analysts had forecast and the -0.1% previously.

Core CPI, which excludes Food, Energy, Tobacco and Alcohol also rose above expectations, reaching 0.9% versus the 0.8% expected.

Despite both being higher, they were still well below the European Central Bank’s (ECB) target of close to but just below 2.0%.

“With the central bank focussing monetary policy tools on boosting growth and inflation, today’s numbers will be taken well and are understandably giving the euro a small lift," says Tom Floyd, Senior Sales Trader at FX specialists Foenix Partners.

According to Nordea Bank’s Holder Sandte, the rise in inflation was ‘not unsurprising’, but regardless would not prevent the ECB from easing in Q4:

“We think that the rise in headline inflation will not prevent the ECB from easing monetary further in Q4, assuming that inflation expectations will remain too from the ECB's perspective.”

Sandte puts the rise down to a lessening in the downwards drag of weaker oil prices, which were only a -6.3% lower than a year ago in June, compared to -8.1% to a year ago in the previous month.

“The year-over-year decline in energy prices fell to 6.5% (from 8.1%) and this trend will continue during the coming months, contributing to higher inflation rates. Headline inflation will likely rise to around 1¼% y/y by year-end.”

This represents a material increase in the rate of inflation, bringing it to within sight of the ECB's target level of 2.0%.

Faced with rising inflation, conventional thinking suggests that the ECB would have to stand back from introducing any further interest rate cuts, or increasing the asset purchase programme, faced with such rapidly rising prices.

This would in turn aid the euro, which is only trading at historical lows thanks to the ECB's policy of cutting rates to ever lower levels.

Danske Bank are in agreement and forecast Eurozone inflation at 1.0% in December this year rising further to 1.5% in February next year after a period when inflation has not been above 1.0% for four consecutive years.

The sharp increase in inflation reflects a fading drag from energy prices after the oil price has risen to the highest level since the end of 2015.

However, Danske expect the ECB will ease again and they look for a QE extension as the ECB in our view will not see inflation on a sustainable path towards 2%.

Analysts believe the ECB will look through the rise in inflation noting the impact of energy prices, rather than a fundamental, and sustainable pick up in core prices.

"We look for a significant increase in inflation starting from June this year, but the main driver is energy prices and this effect is set to fade in Q217. In our view, it could be that the ECB will extend the purchases by six months to September 2017 and also announce a future tapering, where monthly QE purchases are  gradually lowered by EUR20bn per month before ending in January 2018," say Danske.

Growth to falter says Draghi

There are other reasons for the ECB to maintain a proactive easing stance over coming months.

President of the ECB, Mario Draghi, told EU leaders on Tuesday that as a result of Brexit, he expected Eurozone growth to be between 0.3 and 0.5% lower in three years’ time than previously projected.

The slowdown caused by Brexit has led some to expect the ECB to unveil more stimulus despite launching a massive programme of measures in March.

Foenix Partner's Floyd confirms that inflation data could be quite low down the list of concerns for the ECB, given the risks to the financial system and the euro:

“However, in the context of a European state facing risks of contagion from the Brexit vote, highlighted by plunging equity markets, it is unlikely Draghi will be giving the data much credence. As supporting the financial system with sufficient liquidity is likely to remain the key priority, for now, primary data releases remain of secondary importance.”

An Italian Banking Crisis?

The plunge in banking shares following Brexit has left some Italian banks in need of emergency financial support.

This prompted Italian PM Mateo Renzi earlier in the week, to call for the EU to make an exception for Italy so its government could provide financial support to its banks.

As pointed out by analysts at Scandi lender Handelsbanken, the extreme fall in the price-to-book value of many Eurozone banks, after the collapse in their shares will make it more difficult for them to supply credit to institutions, and a tightening in credit situations – a familiar problem for the euro-area - will slow-down Eurozone growth even further.  

“The plunging prices of European banks, not least the Italian banks, has meant that the average price-to-book values are down to extremely low levels making it impossible to imagine any other way for them to sort out their capital needs.

"It also means that the room for new or renewed corporate lending is wiped out and all of ECB’s efforts of to boost lending are nullified. Instead, a possible recession will mean new credit losses, risking some of the banks’ existence.”

In all, the ECB has bigger issues to worry about other than inflation and a continuation of easy policy should keep the euro subdued.