Euro core inflation surprises to the downside

The euro flash CPI came out as expected at 0.3% y/y in September, down from 0.4% y/y. The unrounded number was 0.2549% – so very close to a 0.2% print. The upside risk from the German inflation data yesterday thus failed to materialise as Italian inflation (also released at 11:00) came in slightly lower than expected at -0.2% y/y versus expectations of -0.1% y/y.

The main surprise today, though, came in the core inflation which fell to 0.7% y/y (unrounded 0.683%) versus expectations of an unchanged 0.9% y/y reading. The decline in core was broad based: service inflation fell from 1.3% y/y to 1.1% y/y whereas non-energy industrial goods fell from 0.3% y/y to 0.1% y/y. The low core inflation suggests that declining wage increases are adding to the downside pressure on inflation.

The contribution from food increased a bit as food inflation rose from -0.3% y/y to 0.2% y/y. It suggests that the rise in global food prices seen earlier this year is slowly feeding into consumer prices. We expect food inflation to rise gradually over the rest of the year.

Energy price inflation declined further from -2.0% y/y to -2.4% y/y but this was mainly due to base effects.

We look for inflation to rise over the coming months to 0.5-0.6% mainly due to base effects from energy prices. However, overall inflation is expected to stay subdued for a long time as wage inflation has fallen to a new cycle low recently and commodity prices (not least oil) have come down again in the past few months.

In order to get inflation back to 2%, the ECB needs either (a) strong growth to lower unemployment and push up wage growth or (b) a rise in commodity prices. At the moment, neither of these factors are taking place. Instead, growth has weakened and we see signs of second-round effects in wages where wage setters accept lower wage increases partly due to lower inflation. This risks putting inflation in a lower equilibrium and makes it challenging for the ECB to get inflation back to 2%. The ECB needs a continued weaker euro to help it in pushing inflation up again. It raises the probability of real quantitative easing at some point down the road, although the ECB will also get help from the Fed when it starts raising rates.