Euro Macro: Headline inflation will be volatile, but it’s the core that matters – Eurozone inflation slowed to 1.2% yoy in February from 1.3% in January. This means that headline inflation has essentially been on a slowing trend for the last year (headline inflation peaked at 2% in February 2017). Is this a challenge to the ECB’s plans for an ongoing gradual move towards the exit from super-accommodative monetary policy? We do not think movements in headline inflation are a big driver of the ECB’s thinking right now. The Governing Council is focused very much more on the core. The downward trend in headline inflation over the last year was mainly due to a decline in energy inflation from exceptionally high levels. The most recent decline in headline inflation is due to food prices, which are another volatile item. Perhaps ironically, headline inflation is set to accelerate in the coming months due to a rebound in energy price inflation (which will only be partly offset by further softness in food prices). All these effects tend to fall out of the inflation numbers over time, hence the ECB’s focus on underlying inflationary pressures.
So what of the core? Core inflation was stable at just 1% yoy in February. The key driver of core inflation –wage growth – remains rather subdued given that there is still slack in the labour market. Indeed, the broader – U6 – measure of the unemployment rate stands at around 18%, comfortably above pre-crisis levels. There is some upward pressure on pay settlements because headline inflation is higher than it was a couple of years ago. However, for wage growth to rise significantly, the labour market needs to tighten further. Our base line scenario is that core inflation will take time to embark on a clear upward trend. We expect a slow rise in the second half of the year. This suggests that the ECB will be slow in moving to the exit. We expect the ECB to start tapering its net asset purchases after September, but an interest rate hike will not arrive before the second half of next year. (Nick Kounis)