Investors have been concerned over the risk of deflation in Europe for years, yet the dynamics of prices are set to become more favourable, potentially shifting the balance of risk from deflation back to inflation. Whether this is a permanent shift is highly questionable, as excess capacity remains in the Eurozone.
For the UK, the recent slide in sterling will exacerbate a rebound in inflation that was already due. A little inflation can be a good thing, but too much inflation can also be harmful. We discuss the key drivers of inflation over the next year along with the implications for monetary policy.
Eurozone inflation set to return
The European Central Bank (ECB) will soon need to decide whether or not to extend its quantitative easing (QE) beyond March 2017. The ECB believes the policy has been effective in lowering interest rates across the monetary zone, but the Bank is running out of assets to buy, and the policy is very unpopular in saving countries like Germany and the Netherlands. Therefore, the coming rise in inflation could prove to be a stumbling block for the Bank.
Over the coming months, the impact from the fall in global oil prices late last year will drop out of the base of the annual comparison of prices. This will cause the year-on-year (y/y) inflation rate in most countries to rise, before peaking in the first quarter (as oil prices bottomed out in February 2016).
In forecasting inflation, we tend to take the forward curve of oil prices as a guide to future wholesale prices. While this is often inaccurate in forecasting the spot rate, as many companies use the forward curve to hedge prices, we believe it is as good as any independent forecast.
Historically, the relationship between the monthly y/y change in the Eurozone HICP energy inflation index, compared to the y/y change in the price of Brent crude in euros is roughly a one-fifth pass-through to the energy index from oil.