Lower inflation to spur more ECB action

Headline & core inflation revisit their lows

Deflation fears have intensified again in recent weeks as the sell-off in the oil price continues unabatedly, affecting also prices of other commodities. While the drop in the oil price can also be seen as a positive supply shock, markets tend to look at it from a negative side, especially in Europe where deflation fears are most acute, with inflation back at a 5-year low and just a touch above zero.

After an uptick in October, euro zone CPI inflation dropped again to its cyclical low of 0.3% Y/Y in November, edging closer to negative territory. The sell-off in the oil price will push inflation further down in the coming months, to new multi-year lows. To overlook the effect of the lower oil price, we will keep a close eye on core inflation in the coming months. Since the start of the year, core inflation showed signs of bottoming out, which was encouraging, but in the meantime, core inflation is again at its record low level of 0.7% Y/Y. It will be interesting to see whether second-round effects will also push core inflation further down, to new record lows in the coming months.

Also interesting is to take look at goods versus services inflation, which clearly shows that downward price pressures are led by the goods producing sector.
Remarkably however, the downtrend in goods inflation did not continue during the last few months. Inflation in the services sector extended its downward trend, albeit very slowly. A further slowdown in inflation in the services sector would be a worrying, signalling that deflationary pressures are spreading.

The breakdowns by product groups shows that low inflationary pressures are broad-based. Looking more into detail, also here, there were poor signs in both October and November as the number of product groups with negative annual inflation rates picked up again and reached a new high. Currently the number of product groups with negative annual inflation rates stands at 31%, indicating that one in three product groups is observing negative inflation. While there is no deflation in the meaning of a prolonged period of broad-based declining prices, deflation risks are increasing as downward price pressures are spreading across products groups.

In the meantime, market-based measures of inflation expectations remain on a firm downward trend, falling to ever new lows, indicating that markets believe the latest ECB actions will be insufficient to tackle deflation risks. The steep downtrend in the ECB’s closely-watched 5yr 5yr forward indicates that inflation expectations are no longer “firmly anchored”, which keeps the ECB under pressure to take further action.

Inflation might even become negative

The euro zone headline inflation rate dropped ever lower in recent months and is very close to negative territory.
Inflation was expected to gradually pick up in the second half of the year, but the recent drop in the oil price will delay any stabilization in EMU inflation. Early next year it is even not excluded that inflation might temporary fall into negative territory, before picking up later in the year. To overlook the impact of the oil price, we will keep a close eye on core inflation, which might eventually reach new all-time lows too. The continued downtrend in headline inflation and a new slowdown in the core reading is likely to trigger further action by the ECB, especially as demand from the second TLTRO was disappointing too.