• Upwards. The oil price is soaring, and it is only a question of time before the USD 100 mark falls. At the same time, food prices continue to head north. It is, therefore, no surprise that inflation is rising around the globe. And the medium-term inflation prospects are also deteriorating.

  • EMU. We are, therefore, raising our EMU inflation forecast for 2008 to 2.4%. Early next year, headline CPI will even approach the 3% mark. True, it will weaken again thereafter, but core inflation is expected to drift higher and will clear the 2% hurdle later next year (pages 2-4).

  • US. Gasoline prices will boost US inflation in coming months. Headline CPI should run at over 3% next year and, at the peak, will even reach almost 4%. Furthermore, our calculations show that the core rate, the preferred inflation measure of the Fed, is rising again. Underlying inflation in 2008 is, therefore, nearer to 3% than to 2% (pages 7-9).

  • Monetary policy. Rising inflationary pressure is a dilemma for central banks, since it coincides with persistently high downside growth risks. The Fed and the ECB will, therefore, leave their key interest rates unchanged into next year. Only an unexpectedly sharp slump in private consumption would create easing potential (pages 5-6 & chart below).

  • Further topics:

    • Germany: Budget already balanced in 2007 (page 10).

    • Data outlook: Strong third quarter growth in the eurozone; US industrial production weaker (page 12).

    • Market outlook: At best, a short breather for EUR appreciation, bonds to remain well supported (page 20).


Eurozone: mid-term CPI outlook has deteriorated

  • Eurozone's mid-term CPI outlook has deteriorated. With soaring oil prices and food costs on the rise, we now expect headline inflation to average 2.4% next year, up from the previous estimate of 2.1%.

  • The peak of the CPI projection should be hit between end- 2007/early-2008 at just below 3%, and no decline below 2% is envisaged throughout the forecast horizon.

  • Concurrently, core CPI is seen holding on a moderate upward trend as the lagged effect of closing output gap feeds through.

  • Therefore, the ECB will keep sounding hawkish despite clear signs of slowing GDP. A near-term rate move in either direction is not in the cards, and conditions to resume tightening will probably show up only in H2 2008.


Negative surprise in October

The flash estimate for October inflation showed a strong and unexpected pick-up in headline CPI to 2.6% y-o-y from the previous 2.1%. In two months, the inflation rate has therefore jumped by a cumulative 0.9 pp (it stood at 1.7% in August). Though we think a downward revision to 2.5% remains possible for October, the surprise relative to our 2.4% forecast was fairly large. No detailed breakdown is yet available, but our guess is that energy and particularly food prices were firmer than originally thought. As can be seen from the chart, the pick-up in food prices has been very strong over the last few months, and national data out so far point to a significant increase also in October.

As for core inflation, we had already penciled in a moderate pick-up after the unexpected decline in September, so that any evidence of higher core CPI in October should not come as a major surprise

After the October flash estimate, headline inflation is likely to average 2.1% in 2007 (we previously estimated 2.0%).


Oil and food take a heavy toll

Probably more important in terms of policy implications, the CPI outlook has deteriorated also in the medium term, though only because of non-core dynamics. Higher oil prices and a markedly unfavorable base effect probably added 0.6- 0.7 pp to headline inflation over September-October, and more upward pressure is in the pipeline (cf. chart). Given the recent increase in the crude oil price and the fact that it will be also higher next year than expected so far pushes up our CPI projection for next year by at least a quarter of a percentage point. The y-o-y change in energy costs is now seen peaking above 8% at the beginning of 2008, before easing back gradually thereafter.

Concurrently, the acceleration in food prices so far has been stronger than we had anticipated: we have therefore moderately upgraded our near-term projection, and now see food inflation peaking in the 4-5% area in Q1 2008, about 1 pp higher than previously envisaged. In our view, risks both to the energy and food price outlook remain tilted to the upside.


Core inflation on moderate rising trend

On top of the above mentioned non-core pressures, we continue to like the idea that core CPI will hold on a moderate upward trend for the next quarters. Admittedly, core prices have shown some lack of directionality of late, if anything coming in a touch softer than we had expected. Our inflation gauge that strips out erratic components and administrative prices, in fact, has tended to move sideways after the acceleration at the turn of the year in correspondence with the German VAT hike. But our survey-based slack indicator sug gests that the output gap has turned positive at the end of 2006, and has risen all the way to the end of Q3 2007, when it flattened out as a consequence of the sharp loss of momentum driven by the subprime crisis. Given the lag with which strong activity spills over to inflation (cf. chart), and our forecast that GDP will resume (moderately) above-potential growth in H2 2008, the trend in core inflation should remain upwardly oriented for quite a while – we estimate the peak could be just above 2% sometime in late-2008/early-2009. Of course, the situation would change significantly if we are wrong on GDP and we are entering a prolonged period of sub-par expansion.


We revised up our 2008 CPI call to 2.4%

In this context, we decided to lift our inflation forecast for next year from 2.1% to 2.4%. Our projection envisages a further CPI acceleration in the next few moths, with the peak of the inflation path to be hit at end-2007/early-2008 at about 2.8%, despite the favorable base effect related to last year’s VAT hike (cf. chart). While a deceleration in headline inflation seems likely from spring onwards as energy pressures mitigate, we hardly see room for any CPI decline within the ECB’s definition of price stability throughout the end of 2008.

While 2.4% in headline CPI may seem an aggressive call, ours is by no mean a worst-case scenario, as oil and food price risks still appear skewed to the upside.


ECB: hawkish rhetoric is here to stay

While the ECB had long been warning about a likely CPI acceleration due to base effects between end-2007 and early- 2008, it is increasingly clear that the extent of the pick-up (current and perspective) caught the central bank by surprise. Accordingly, an upward revision – possibly significant – to the ECB’s inflation projection for next year is virtually a done deal. However, this will be presumably accompanied by a (moderate) downward adjustment to the GDP forecast for 2008, so that policy implications are not straightforward. Our view is that, as long as the inflation acceleration is driven mostly by non-core components, the ECB can afford to wait and gather more information on the extent of the GDP deceleration and the effect of the credit crisis on the real economy. After all, the abrupt slowdown in the new orders index of the manufacturing PMI calls for close monitoring, while our Taylor Rule suggests that the refi rate is now very much in line with fundamentals (cf. chart).

However, if GDP eases below trend only moderately around the turn of the year and gradually regains traction thereafter, the ECB will not miss the opportunity to resume tightening sometime in H2 2008. This remains our baseline scenario.