- Eurozone inflation continued to fall in January…
- …which could well trigger ECB to remove SMP drain at this week’s meeting
- Inflation in Japan heads higher, but BoJ may need to do more to meet target
Eurozone inflation fell further in January…
Eurozone inflation fell to 0.7% yoy in January from 0.8% in December. It was in line with our own expectation, but below the consensus forecast of a rise to 0.9%. The decline in inflation was due to downward effects from energy and – to a lesser extent – food prices. Core inflation edged up (to 0.8% from 0.7%) but still remained below November’s level (of 0.9%).
…and we expect further falls in coming months
We expect headline inflation to fall further in the coming months. Underlying inflation pressures are dissipating because of the high level of slack in the labour market, which is pushing down labour cost growth. Indeed, unemployment remains at extremely high levels and downward pressure on wages is likely to persist for some time to come. Meanwhile, the strength of the euro and subdued global manufactured goods and commodity prices will also suppress import price inflation. Although we do not expect the region to fall into outright deflation, the eurozone is become increasingly vulnerable to such an outcome in case of a new unexpected demand shock. In any case, inflation is likely to settle at levels far below the ECB’s price stability goal for the foreseeable future. Meanwhile, the eurozone money market has remained relatively tight, keeping upward pressure on interbank rates and the euro relatively strong over recent weeks.
ECB may stop SMP sterilisation at this week’s meeting
We expect the ECB to take action to ease monetary policy further, possibly as soon as this week’s meeting. We think that the ECB’s most likely first step will be to provide liquidity to the system by stopping the sterilisation of the SMP. This should push down interbank rates at the short end to previous levels, as well helping to push down short rate expectations. If this fails to have traction on financial conditions, then we think that the ECB would most likely cut rates further, with the deposit rate moving into negative territory. Given the uncertainty about the side effects of negative rates, the central bank’s initial step might be to cut both the refi rate and deposit rate by a smaller than usual 10bp step. In this scenario, March or April would be possibilities for a rate reduction. We think that the ECB would only turn to an asset purchase programme if deflationary risks really intensified.
Japan’s inflation moving higher, but target still in doubt
Inflation in Japan rose to 1.6% yoy in December from 1.5% in November. The core rate, which excludes fresh food and is the benchmark of the BoJ, also rose but sits at a lower level. It edged up 1.3% from 1.2%, taking it closer to the 2% target. Recent trends suggest that the BoJ’s monetary stimulus is having a positive impact. The highly accommodative monetary stance has weakened the yen. The depreciation of the currency led to a rise in the prices of imported goods and services, fuel in particular. However, there remain significant doubts about whether the BoJ will actually hit its inflation target over time. First of all, the impact of the yen’s drop looks to be waning. If the rise of import prices doesn’t gradually spill over to other items, the cost push induced inflation increase will lose momentum. For a broader sustained rise in inflation, we need to see sustained strength in domestic demand and rising wages. Both are in doubt. So far domestic demand has received a boost by the prospect of the sales tax increase from 5% to 8% in April. But fears are that demand receive a hit once the sales tax hike is actually implemented. Meanwhile, the government has been trying to persuade employers to use improved profitability to boost workers’ salaries. Although the latest reports show that the labour market is tightening it is unclear whether employers are willing to raise wages. Overall, the BoJ may well need to step up monetary stimulus in coming months, to provide more support to domestic demand and put further downward pressure on the yen.