Draghi’s inflationary headache: analysts react to eurozone’s 2% inflation

A novel dilemma for the European Central Bank to contend with: above target inflation.

Prices in the single currency area have climbed by 2 per cent on the year for the first time in over four years, posing a fresh headache for the ECB’s dovish policymakers who will mark their two-year quantitative easing anniversary next week.

At the ECB’s latest meeting next Thursday, president Mario Draghi will face the task of convincing his more hawkish colleagues that the current leap in annual prices – from 1.8 per cent in January – is unlikely to be sustained having been driven by volatile energy costs. The central bank, which has been battling with more than three years of low prices, targets inflation of just under 2 per cent.

Here’s what analysts are making of Mr Draghi’s dilemma.

Despite the recent upsurge in inflation driven by higher oil prices Pete Vanden Houte at ING thinks inflation will begin to stabilise over the coming months. If anything, he says the ECB will opt to let inflation run above target to compensate for years of weak prices:

There is little doubt that the ECB will continue to be criticized for its loose monetary policy, especially in the core countries. But the bank will no doubt recall that the inflation target has to be reached over the medium term and for the whole of the Eurozone. If anything the ECB is more likely to err on the side of inflation, to compensate for the fact that consumer price increases have significantly undershot the ECB’s target for now 4 years in a row.

We therefore don’t see any change in monetary policy this year. However, in the third quarter, the ECB might announce its exit strategy, which in our view will probably entail a new extension of the QE program until mid-2018, but with some tapering included.

Perhaps more importantly for the ECB, a measure of core inflation that strips out volatile oil prices remained unchanged at just 0.9 per cent last month and has not climbed over 1 per cent since August 2013 (see chart above).

Core inflation has been kept subdued by a moderate pace of wage increases in the eurozone. Higher wages are important in underpinning a sustained rise in inflation, but signs of salary increases are still not evident despite falling unemployment, said Jennifer McKeown at Capital Economics.

Other data today revealed that a small fall in the number of unemployed people left the euro-zone unemployment rate unchanged at 9.6%, which is close to most estimates of the structural rate, implying that wage growth may be set to rise.

However, there are few signs of this happening so far, even in Germany where the labour market has been very strong for some time. After its meeting next week, the ECB is likely to reiterate its view that the latest pick-up in inflation will be transitory and we see the Bank carrying out this year’s asset purchases as planned.

Fabio Fois at Barclays thinks the divergence between core inflation and headline inflation will continue to swell in the coming months but headline prices should ease back towards the end of the year:

Headline HICP inflation will not stay at such high levels for long. In particular, as base effects from energy fades and unprocessed food prices rally loses momentum, we expect headline inflation to start decline from Q4 onwards towards 1.3% by the end of next year.

Core inflation will remain on a moderate recovery trend through the forecast horizon, in our view, as labour market slack in the euro area economy remains substantial and this is likely to dampen wages for a few more quarters.

Analysts at Fathom think weak core inflation coupled with an uneven inflationary performance across the eurozone’s 19 member states, mean “expectations of ECB tightening are premature”.

Annual inflation in Spain has registered at 3.1 per cent in Spain, 2.2 per cent Germany but is bumping around 1 per cent in Ireland and fell to 1.4 per cent in France last month.

Still, Julien Lafargue at JPMorgan Private Bank thinks “the ECB might have to consider slowly reversing course, starting by revising its economic projections upward and tweaking its language before bringing back the topic of tapering eventually”.