Deflationary pressure are spreading

At the start of the year, markets were still under the spell of deflation, ahead of the January ECB-meeting. The ECB delivered more than expected and announced a huge QE package. In the meantime, also the sell-off in the oil price ended with the oil price picking up slightly. As a result, deflation fears have eased since and also inflation expectations started to pick-up, albeit from low levels and very gradually.

Both headline and core CPI at record lows

Nevertheless, EMU inflation data continued to surprise on the downside of expectations. CPI inflation dropped to -0.6% Y/Y in January, matching the record low of 2009.
Although the sharp drop in inflation was mainly due to sell-off in the oil price, also core inflation fell to a new record low (0.6% Y/Y from 0.7% Y/Y). This suggests that downward price pressures are not only based in energy and might be filtering through into prices of other goods and services.

Deflationary pressures are spreading

Looking at the sector breakdown, not only prices in the goods-producing, but also in the services sector slowed significantly in January, from 1.23% Y/Y to 1% Y/Y. A closer look at the sector details show that deflationary pressures are spreading across product groups, pointing to possible second-round effects from the lower oil price. The number of product groups with negative annual inflation rates picked up in January, to 34% from 30%. Nevertheless, volatility is usually high in January due to seasonal factors (end of the holidays, winter sales). One in three product groups is observing negative annual inflation, which is a high amount, but no deflation in the meaning of a prolonged period of broad-based declining prices. The breakdown by country nevertheless shows that deflationary pressures are broad-based across countries with only Austria observing positive inflation.

In the meantime, market-based measures of inflation expectations (10yr inflation swap) picked up slightly, from 1% a month ago to 1.2% currently. It suggests markets believe disinflationary pressures are no longer accelerating. The ECB’s closely-watched 5yr 5yr forward picked up slightly, from 1.5% to 1.6%. This indicates that markets believe the ECB’s measures are still insufficient to reach the 2% target in the medium term.

…but higher oil price and weaker euro should support inflation later this year

Both euro area headline and core inflation are at record low levels due to the combination of a prolonged period of very slow growth and the recent sell-off in the oil price.
Since the start of the month however, the Brent crude oil price picked up, which should push costs of transportation and household energy somewhat higher. Nevertheless, it will take time before the effects of the sharply lower oil price since the middle of last year have completely filtered through. As a result, both headline and core inflation might still edge somewhat lower in the coming months, before starting to pick up. Later on, the weaker euro, stronger domestic demand and probably the rebounding oil price (if continued) should push inflation somewhat higher. Nevertheless, it will take time before inflation will return again to the ECB’s 2%-target.