Euro: Lower headline inflation, but higher core inflation

Inflation in the euro area has declined to a new cycle-low of 0.3% y/y in August. Inflation has only been this low following the financial crisis in 2009.

The decline in inflation in August was mainly due to lower energy price inflation. It dropped to -2.0% y/y from -1.0% y/y, which was mainly due to lower oil prices. Food price inflation remained unchanged from June and was -0.3% y/y. This followed due to a monthly decline of 0.2%, which is not unusual in August.

On the other hand, core inflation increased to 0.9% y/y in August from 0.8% y/y in July. Although core inflation is still low, it is positive that it has stabilised during the past three months and even increased in August. This should reflect that the second round effects from the decline in commodity prices are still modest. Seen from an activity perspective, this is also positive, as the stable core inflation is likely to reflect stable nominal wage growth and with lower headline inflation, this results in higher real wage growth.

The decline in inflation in August is likely to imply that the ECB will lower its inflation projection for 2014 once again. The current forecast for 2014 is 0.7% and on Thursday at the ECB meeting, we expect a lowering of the projection to 0.6%. Looking at the forecasts for 2015 and 2016, there is some upside risk to the current projections, as the exchange rate has weakened since the latest forecast was made. We expect these projections to be left unchanged.

The persistent low inflation has resulted in a considerable decline in marketbased inflation expectations during August and lower actual inflation and the higher likelihood that the ECB will lower its inflation forecast could result in a further decline in market-based inflation expectations. On the other hand, the lower inflation also increases the likelihood of more easing from the ECB and expectations that the ECB could go down the QE path could give some upward pressure on inflation expectations.

Overall, the likelihood of further ECB easing has increased after ECB President Draghi held a dovish speech last week where he mentioned declining inflation expectations in August. The comment has fuelled QE expectations as Draghi previously coupled de-anchored inflation expectations with large scale asset purchases. However, we still believe the bar for QE is high at least in the near term. Instead, we expect more details on an ABS programme at the September meeting (see ECB easing – will it work? #5: ECB’s policy going forward, 29 August 2014).