Euro area: Core inflation surprises on the upside again

Euro area HICP inflation was unchanged at 0.2% y/y in July, in line with consensus expectations, but core inflation surprised on the upside again as it rose to 1.0% y/y in July from 0.8% in June (consensus 0.8% y/y, Danske 0.9% y/y).

Core inflation is now the highest it has been since April 2014. The increase in July followed a jump in core inflation from 0.6% y/y in April to 0.9% y/y in May. The higher core inflation is driven by both higher service price inflation, which was 1.2% y/y in July up from 1.1% y/y in June, and non-energy industrial goods price inflation, which was 0.5% y/y in July after printing 0.3% y/y in June.

Non-energy industrial goods price inflation, which has a weight of around 40% in core inflation, has now increased for five consecutive months. The higher inflation rate is supported by a lagged impact from the weaker effective euro, the indirect impact of the higher oil price in Q2 and stronger domestic demand.

Services price inflation, which constitutes the remaining 60% of core inflation, has been affected by seasonal factors, but seems to have moved away from the historically low level of 1.0% y/y. For services price inflation to increase further, the labour market would have to be stronger and in our view wage pressure in the euro area will remain modest in 2015 and 2016. At the end of 2016, the unemployment rate should approach its structural level, implying upward pressure on wages should resume.

Headline inflation was unchanged even though the oil price has dropped in July. This resulted in lower energy price inflation of -5.6% y/y in July, down from -5.1% y/y in June. This was due to a monthly decline of 0.7%, which shows that the lower oil price has not yet resulted in lower gasoline prices in the euro area. Food price inflation was weaker than expected as it declined to 0.9% y/y from 1.1% y/y due to a monthly fall of 0.5% m/m.

We still expect euro inflation to increase sharply later this year. At the end of this year, the drag from energy price inflation will fade despite the latest decline in the oil price. This is because the oil price measured in EUR is currently higher than the price at the beginning of the year, implying the yearly change will increase above 0.0% if the oil price stays at the current level.

Assuming the oil price is unchanged around the current level, the contribution from energy price inflation will go from -0.6pp in September to +0.3pp in January next year due to base effects only.