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German Inflation Disappointment adds to Growing ECB Headache, Constrains Euro Outlook

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- EUR outlook grows darker as doubts about inflation trajectory mount.

- Inflation picture may force ECB to abandon 2019 "normalisation" plan.

- But financial system gets clean bill of health, will cope with next crisis.

German inflation data for November came in on the week side, adding to the sense of a slowdown in the Eurozone's key economy and expectations that the European Central Bank (ECB) might have to delay plans to normalise monetary policy which is likely to have knock-on effects for the Euro's outlook.

According to Destatis, German inflation for November read at 0.1% on a month-on-month basis, coming in below expectations for a reading of 0.2% while annualised inflation stands at 2.3%, below the 2.4% expected.

Analysts say inflation could be on course for further declines over the coming months, given the boom-to-bust shift in oil markets that took place this month.

"We are fairly confident that energy inflation will fall soon, both in Germany and in the euro area as a whole," says Claus Vistesen, chief Eurozone economist with Pantheon Macroeconomics.

The deteriorating inflation outlook adds to headwinds for the Euro stemming from slowing growth on the continent. German GDP growth fell to -0.2% in the third-quarter while Eurozone growth halved to just 0.2%.

The growth outlook has been dented of late by a range of factors including new regulations in the automotive sector and the effect President Donald Trump's "trade war" could have on export-dependent countries like Germany.

This has already undermined market confidence in the ECB's forecast that inflation will soon be able to sustainably meet the bank's target of "close to but below 2%" because a pickup in organic inflation pressure requires "above potential" economic growth.

"With crumbling and more uncertain growth prospects and very little underlying inflationary pressure in the entire eurozone, the ECB will be happy that the December meeting is not too far away and that it can bring net QE purchases to an end before discussions about an extension could flare up again," says Carsten Brzeski, an economist at ING Group.

"Staff macroeconomic projections envisage a slight moderation in real GDP growth from 2.0% in 2018 to 1.7% in 2020 amid a weaker stimulus from world trade and growing labour supply shortages. This euro area outlook continues to contrast with more buoyant developments in the United States," the ECB says, in its latest financial stability report

The European Commission estimates potential growth to be around 1.5% and the ECB forecasts GDP will grow above the potential rate over coming years, but momentum is falling and even in the bloc's best post-crisis days back in 2017, inflation pressures were not strong enough to support a return to target. 

This is important because the Euro's appeal to investors is currently hinged upon the ECB ending its quantitative easing programme in December and beginning to lift its interest rates from record lows in the final quarter of 2019. But the inflation outlook is still deteriorating, placing a question mark over whether the bank will make it to the finish line. 

"We continue to expect the ECB to face considerable headwinds next year that could delay the first interest rate rise," says Neil Wilson, a strategist at Markets.com. "Draghi and co have been sticking resolutely to their inflation expectations despite the signs that indicate that convergence with target will be slower than forecast."

Wilson says there's a danger the ECB ends its QE programme in December only to be forced into resuming stimulus further down the track when higher inflation fails to materialise. There is precedent for such u-turns at the ECB.

After cutting rates to 1% in the wake of the 2008 financial crisis, the bank raised the benchmark borrowing cost to a peak of 1.5% before the end of 2011, only to be forced into retreat by the debt crisis that flared up that very year. 

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The ECB has a history of being slow to respond to changes in the outlook for inflation and the economy too.

In 2008 and 2009, after the financial crisis, the Bank of England and Federal Reserve cut their interest rates to record lows of 0.5% and 0.25% respectively and began quantitative easing. 

The ECB's rate did not reach parity with either of these levels until 2013, and it didn't start quantitative easing until 2015, despite the inflation picture at the time being very similar to the current one.

"The ECB will, for the time being, try to tackle any growth slowdown as well as stubbornly low core inflation with forward-guidance on rates and the length of the reinvestment programme. If things really get nasty, next year’s discussions on the timing of the first rate hike could easily morph into discussions on whether the second unconventional measure (negative deposit rates) should be shelved or whether to hike rates at all," ING's Brzeski warns. 

The Euro-to-Dollar rate was quoted 0.07% higher at 1.1376 Thursday but is down 5.1% for 2018, while the Euro-to-Pound rate was 0.44% higher at 0.8804 and has risen 0.634% this year.

 

ECB Gives Eurozone Financial System the Thumbs Up

Price action, and the German inflation figures, came alongside the release of the European Central Bank's latest financial stability report.  

Risks to the banking sector are judged as contained, according to the ECB, given improvements to capital buffers over recent years and progress by Italian and Spanish institutions in their efforts to reduce the stock of toxic debts on their balance sheets. Many of those date back to the debt crisis years.

This is despite companies operating in an environment that has become "more challenging", with Federal Reserve interest rate policy having rocked the developing world and President Donald Trump's trade policy upsetting the apple cart in global markets this year. And not to mention, Brexit.

The ECB says that even another bout of severe volatility in emerging markets would have only a limited impact on the stability of the banking sector, even if such an event does ultimately end up destabilising some fund management companies as well as global financial markets in general.

And the U.K.'s pending exit from the European Union presents only a limited risk to financial stability, so long as it is an "orderly withdrawal". Although banks should make preparations for how they would respond to a "no deal Brexit" to avoid disruptions to their businesses and mitigate the "more significant downside" risk presented by that scenario. 

Despite the positive, the bank warned that further progress toward a so-called capital markets union is necessary for confidence in the supervisory regime to be maximised and underpinned. This requires a deposit insurance scheme and shared liability among EU members for rescuing or repairing damage done by any banks that go bust within the region. 

The report means the continent's banks could well manage any instability that comes their way over the short-term, but it does little to improve a deteriorating outlook for the single currency, which was underlined Thursday by both the ECB, German inflation figures for November and analyst commentary.

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