Has EMU inflation reached its bottom?

Euro zone inflation falls ever lower, but.

The ECB announced earlier this month new measures in an attempt to bring inflation again in line with the 2% medium-term target. Nevertheless, calls continue for a full blown QE package, namely purchases of government bonds to minimize the risk of deflation. It is still early days, but recent developments suggest that risks of deflation are receding. If this would be confirmed in the next months, it may silence the calls for extra measures within and maybe outside the ECB.

Euro zone CPI inflation remains stubbornly low and far below the ECB’s target of inflation below but close to 2%. According to the first estimate, inflation slowed further to 0.3% Y/Y in August, but the final reading showed an upward revision to 0.4% Y/Y. Despite the continued downtrend in headline inflation, core inflation, rose for a fourth consecutive month in August, nearing 1% Y/Y as the recent slowdown in inflation was mainly due to lower food & energy prices. Disinflation because of lower food and energy prices should however be seen as a positive supply shock rather than a deflationary threat as it increases real disposable income.

Also interesting is to take look at goods versus services inflation, which clearly shows that downward prices pressures are led by the goods producing sector. Sluggish global growth, which weighs on commodity prices, is at least partially a factor. Inflation in the more domestically-oriented services sector is low, due to still sluggish domestic demand, but shows signs of bottoming out.

The breakdowns by product groups shows that low inflationary pressures are broad-based. Looking more into detail, it is encouraging to see a decline in the number of product groups with negative annual inflation rates. In June, almost one in three product groups were observing negative inflation rates. In both July and August, the percentage of product groups with negative annual inflation rates dropped and is currently less than 24%. Although it is still early days, it might be an indication that the risk of deflation, in the meaning of a prolonged period of broad-based declining prices, is easing. We will keep a close eye on this indicator in the coming months, to see whether this encouraging trend continues.

Despite these signs of improvement, market-based measures of inflation expectations remain low. After the ECB’s measures earlier this month, inflation expectations picked up, but have declined again recently with 5yr 5yr forward at a new low, suggesting that markets are not really convinced that the latest actions will be sufficient.

…growing signs that deflation risk is easing

The euro zone headline inflation rate dropped ever lower in recent months, but the underlying picture shows some signs of improvement. Core inflation rose already for four consecutive months and the number of product groups with negative annual inflation rates declined for two straight months. We believe that the headline inflation rate might have bottomed, although a further drop is not entirely excluded due to the recent drop in the oil price. Towards the end of the year, inflation will probably start to pick up, but any uptick in inflation will be very gradual as the economic recovery in the euro area remains disappointingly slow and insufficient to substantially boost prices.