Measuring the euro area inflation pulse · inflation conundrum persists 2. Theme: are external forces subduing underlying price pressures? 3. Euro inflation outlook: ECB inflation

Euro Area ResearchMeasuring the euro area inflation pulse

Aila MihrSenior Analyst+45 45 12 85 [email protected]

29 November 2019

Important disclosures and certifications are contained from page 32 of this reportwww.danskebank.com/CI

Investment Research – General Market Conditions

22

Contents: Measuring the euro area inflation pulse

1. Euro inflation rewind: the missing core

inflation conundrum persists

2. Theme: are external forces subduing

underlying price pressures?

3. Euro inflation outlook: ECB inflation target

remains as elusive as ever

4. Inflation market dynamics: still looking for the

missing catalyst

• No turning point in underlying inflation yet in sight, despite robust wage growth.

• Lack of exchange rate pass-through important for the stickiness in core inflation.

• Acceleration in service prices ahead but f lagging goods inflation presents a less cheering picture.

• Market pricing in mid-2020 on the low side, even without material pickup in core inflation.

Note: Past performance is not a reliable indicator of current or future results

Source (all charts): Eurostat, ECB, Macrobond Financial, Danske Bank

Euro inflation rewind:

the missing core inflation conundrum persists

44

• Headline inflation continued on a downwardtrend, due to an increasing drag from lowerenergy price inflation and slowing food priceinflation.

• Increasing base effects from 2018’s strongincrease in oil prices and less steep priceincreases for vegetables (which increased bysome 7.3% in H1 19 following the 2018 dryspell) were key drivers.

Euro inflation rewind: Q3 brought little to cheer ECB

1. Euro inflation rewind: the missing core inflation conundrum persists

• Core inflation stayed subdued around the 1%level, without a discernible upward trend.

• Non-energy industrial goods (NEIG). Durablegoods prices fell deeper into deflation territoryand non-durable goods price inflation isincreasingly feeling the drag from slowerproducer prices (see p. 24-25).

• Services. While the technical drag from a weightshift in German package tours is receding (seep. 7), other categories have yet to show a clearrise (see p. 26-27).

Source: Eurostat, Macrobond Financial, Danske BankSource: Eurostat, Macrobond Financial, Danske Bank

55

Some slowdown in wage growth in sectors hithardest by the economic weakness (industry, retailand wholesale trade)

Wages: pre-conditions for higher core inflation remain in place in

light of service sector resilience…

Source: ECB, Macrobond Financial, Danske Bank


…and negotiated wage growth still the main driver(see twitter), pointing to persistent wage pressure.

Wage growth in service sector remains high...



https://twitter.com/aila_mihr/status/1197138897165307904

66

…yet super core inflation has stalled its uptrend since 2018, not pointing to an imminent turning point in the core inflation dynamics

…still, the missing core inflation conundrum persists

Wage growth remains close to the highest level in 10 years…

…and the number of core inflation items above 1.5% is edging up…


Excluding package tours, a moderate uptrend is still intact

Source: Eurostat, ECB, Macrobond Financial, Danske Bank




77

The core inflation drag from technical changes inthe weight of German package tours will fade byend-2019

Disregarding package tours, German core inflation is picking up…but euro area equivalent remains more sticky

Underlying inflation: package tours blur the picture (yet again)

Source: Eurostat, Macrobond Financial, Danske Bank



Theme:

are external forces subduing underlying price

pressures?

99

• Both domestic and external forces drive inflation developments in the short term.

• On the domestic side, price pressures are largely determined by unit labour costs, profit margins and thepricing power of firms.

• On the external side, inflation dynamics are affected mainly by import prices for commodities, as well asintermediate and final consumption goods.

Domestic vs external drivers of inflation

HICP excl. energy & food

ProductivityDomestic

slack

Wages/slack

Inflation expectations

Energy

Producer prices

Import prices

Global slack

Foreign goods

Food prices

Oil prices

Commodities

External drivers

Domestic driversExchange rate

Food

Global value chains

?

2. Theme: are external forces subduing underlying price pressures?

Source: ECB

1010

Domestic inflation measures have increased – why hasn’t core inflation?

Are external forces subduing underlying price pressures?

• Core inflation in the euro area has remainedstubbornly low despite an uptick in wage growth.Instead of looking for the culprit among measuresof domestic slack, should we rather look for thedriver in external factors?

• To get a clearer picture of domestic versusexternal drivers of inflation, it can be useful tocompare core inflation and the GDP deflator. Whilecore inflation includes prices for imported goodsand services, the GDP deflator measures onlyprices of final domestically produced items.

• Core inflation and the GDP deflator had tended tomove broadly in line but a divergence has openedup recently. The GDP deflator has accelerated(as has our locally generated inflation measure),while core inflation has remained broadly flat.This would suggest that part of the decouplingoriginates from external factors.

• In the following we take a closer look at three key

channels: (A) the ‘global factor’, (B) the exchange

rate and (C) digitalisation.Source: Eurostat, Macrobond Financial, Danske Bank


1111

‘Are central banks still masters of their domestic

monetary destinies? Or have they become slaves to

global factors?’ – Mark Carney (2015)

(A) The global factor

• The close link between euro area PPI forconsumer goods and Chinese export prices aswell as the declining dispersion of core inflationrates across OECD countries bear witness to theclaim that global value chain integration hasincreased synchronisation of global businesscycles and inflation.

• Studies have explored whether low globalinflation has brought low inflation to the euroarea through cheaper imports as well asincreased labour mobility and competition.However, empirical research (see p. 12) suggestsonly a very limited role of global factors inexplaining core inflation movements in the euroarea.

• Despite the mixed empirical results, broaderstructural drivers may be shaping inflationworldwide in ways that are yet to be fully graspedbut monetary policy regimes might also be animportant part of the explanation.

Less dispersion of core inflation in OECD countries


External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

Chinese export prices important for euro PPI

Source: Eurostat, OECD, Macrobond Financial, Danske Bank

Source: Eurostat, OECD, Macrobond Financial, Danske Bank

https://www.bis.org/review/r150902a.pdf

1212

IMF Working Paper ‘Understanding Euro Area Inflation Dynamics: Why So Low for So Long?’, No. 18/188, August 2018

• ‘We find that domestic factors dominate global factors in

explaining recent inflation dynamics. Global factors do not help

to explain the recent low inflation episode.’

(A) Studies on the ‘global factor’ in inflation

find mixed evidence

ECB Economic Bulletin Article ‘Domestic and global drivers of inflation in the euro area’, 4/2017

• ‘The theoretically appealing idea that domestic wage and price

pressures are increasingly affected by global developments via

higher integration and increasing contestability of labour and

product markets is difficult to capture empirically. In this

respect we find only limited support for including measures of

global slack and of the integration in global value chains in

Phillips curve analyses of inflation in the euro area.’

BIS Working paper ‘Has globalization changed the inflation process?’, No. 791, July 2019

• ‘Global factors, including exchange rates, oil prices, other

commodity prices, slack in major economies (not just at home)

and international pricing competition, can all be important

determinants of inflation. Although results vary across

individual countries, the role of these global factors in explaining

CPI inflation rates has increased over the last decade. ‘

European Commission ‘Has inflation become more global? ’,Spring 2018 Economic Forecast

• ‘Inflation in the OECD countries has a common factor, whose

relevance increased after 1999.’


Studies find negative contributions from external factors to underlying inflation are relatively modest

External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

https://www.imf.org/en/Publications/WP/Issues/2018/08/22/Understanding-Euro-Area-Inflation-Dynamics-Why-So-Low-for-So-Long-46134

https://www.ecb.europa.eu/pub/pdf/other/ebart201704_01.en.pdf

https://www.bis.org/publ/work791.pdf

https://ec.europa.eu/info/sites/info/files/economy-finance/ecfin_forecast_spring_030518_boxes_1_en.pdf

1313

• In light of the seeming divergence between coreinflation and the GDP deflator, recent importprice dynamics bear closer investigation.

• The exchange rate plays an important role inshaping movements in import prices and affectscore inflation both through direct (i.e. via theprice of imported final consumer goods) andindirect channels (i.e. via the price of importedintermediate goods used in production).

• Amid the core inflation items, it is primarily NEIGwhich are sensitive to FX movements, witharound 15% of items constituting directlyimported consumer goods.

• The exchange rate pass-through works mainlythrough durable goods, although the effect cantake up to two years fully to work its way throughthe pricing chain. Semi-durable NEIG prices areaffected as well but effects are significant only inthe short term, while prices of non-durable NEIGhardly respond to an exchange rate shock at all(see chart for elasticities).

(B) The exchange rate: an import driver of

NEIG inflation

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

1 2 3 4 5 6 7 8 9 10 11 12

(annual percentage change, pp. contribution)

non-durable NEIG

semi-durable NEIG

durable NEIG

NEIG

Note: The x-axis refers to the quarters following a change in the exchange rate

Source: Eurostat, ECB calculations

-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

1 2 3 4 5 6 7 8 9 10 11 12

Impact on core inflation


Estimated impact of a 10% appreciation of the nominal effective exchange rate of the euro on NEIG inflation

External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

https://www.ecb.europa.eu/pub/pdf/ecbu/eb201804.en.pdf?cb2d86a64d597f8e99bfc2a253ba2fb7

1414

(B) Import prices: from headwind to tailwind

• Recent movements in the effective exchange rateand import prices point to a fading headwind toinflation. After appreciating by 5.3% in 2018, theeffective euro (EER-38) has started to depreciateagain this year (by -0.9% so far). This has givenrise to an increase in import prices.



• However, durable goods price inflation seems tohave decoupled from import prices.

• The tailwind from import prices has so far failedto show up in durable goods price inflation withthe usual 6M lag.

External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation


1515

• A closer look at the sub-components of durable goods reveals that audio visual (AV) equipment andhousehold appliances have exerted an increasing drag since 2018. More recently, lower price increasesfor vehicles have also contributed to deflationary pressures (especially in Germany, wheremanufacturers are currently battling with structural changes in the car industry).

• For two of these three durables items (AV equipment and to some degree also household appliances),import prices would suggest an acceleration lies ahead.

(B) Durable goods prices are defying the rise

in import prices


External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

Source: Eurostat, Macrobond Financial, Danske Bank Source: Eurostat, Macrobond Financial, Danske Bank

1616

(B) Euro area firms see their pricing power

eroded by economic slowdown

• Still, we see reason to remain sceptical on the outlook for durable goods prices (see p. 24). Various factorsdetermine the degree of exchange rate pass-through (ERPT), including the pricing power of firms, theinvoicing currency choice and the type of shock driving the exchange rate movement.

• Business surveys show euro area firms are becoming more gloomy about their competitive position andpricing power (particularly for vehicle producers). Hence, firms remain reluctant to pass on higher inputcosts – be it from wages or FX moves – to consumers to protect market shares. We doubt that thisdynamic will change materially as long as the euro area economy continues to be so fragile.

Source: Eurostat, European Commission, Macrobond Financial, Danske Bank


Source: Eurostat, European Commission, Macrobond Financial, Danske Bank

External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

1717

• Euro area economies with a smaller share of theeuro as invoicing currency for extra-euro areaimports tend to experience a significantly higherdegree of ERPT.

• Although the cross-country variation in the use ofthe euro as invoicing currency remainssignificant, the overall share of the euro as aninvoicing currency has been remarkably stable inthe past decade and has hovered around50-60%. Hence, it is not a compelling argumentto explain the recent muted ERPT.

(B) Share of euro currency invoicing has been

stable over past decade

Source: ECB, Danske Bank


Inverse relation between exchange rate pass-through and share of local currency invoicing

External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

1818

• The size of ERPT to inflation is also affected byprice rigidities and the perceived persistence ofshocks.

• The recent euro depreciation has been relativelybroad-based. More persistent euro weaknessextending into 2020, coupled with a stabilisationin the business cycle, could diminish producers’current reluctance to raise consumer prices.

(B) More persistent EUR weakness increases

risk of pass-through



• We see the EUR as undervalued at current levelsbut it is difficult to see the tide turning anytimesoon: a sudden hawkish shift at the ECB seemsunlikely and with interest rates in the eurozoneamong the most negative in the world, the euro isincreasingly becoming a key funding currency forcarry trades – weighing on the currency despitefading eurozone capital outflows (see FX

Essentials: EUR – a floor and a failed recovery, 18November).


External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

https://research.danskebank.com/abo/FXEssentials181119/$file/FXEssentials_181119.pdf

1919

Overall ICT inflation has been negative but its contribution to HICP has been subdued

(C) Digitalisation cannot explain the

unattainability of the ECB’s inflation target

In Euro Area Research - Inflation’s race against the

digital machine, 27 November, we took a closer lookat the effect of digitalisation on inflation.

• In summary, we find scant evidence that digitaltechnology is the culprit for the unattainability ofthe ECB’s inflation target.

• While information and communicationtechnology (ICT) related inflation has generallybeen negative, its contribution to HICP has beenrelatively limited.

• Furthermore, it is difficult to find strong evidencethat digitalisation and labour substitutionthrough automation can be blamed for thecurrent low inflation outcomes, with unit labourcost growth remaining close to the highest levelin 10 years.

• And while e-commerce might have increasedcompetition and price discovery, an ECB study

finds only a very limited impact of -0.04pp oncore inflation.


External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation


https://research.danskebank.com/research/#/Research/articlepreview/617c4958-bb92-4d01-90a0-5abd5b3d8428/EN

https://www.ecb.europa.eu/pub/pdf/scpops/ecbop181.en.pdf

2020

• Studies find the negative contributions from externalfactors to underlying inflation to be relatively modest. Still itis difficult to dismiss completely the ‘global factor’, asbroader structural forces may be shaping inflation globallyin ways that are yet to be fully grasped by the data.

• Although digitalisation’s impact on inflation has been widelydebated, we find scant evidence that digital technology isthe culprit for the unattainability of the ECB’s inflationtarget. While ICT-related inflation has generally beennegative, its contribution to HICP has been relatively limited.

• Instead, the seeming lack of exchange rate pass-through todurable goods price inflation since the start of 2019 hasbeen a non-negligible factor behind the stickiness in NEIGand core inflation. While higher import prices still suggestan acceleration lies ahead, companies’ perception ofdeclining pricing power on the back of the economicslowdown leaves us sceptical about an imminent uptick ingoods prices. Upside risk remains from more persistentEUR weakness extending into 2020.

Summary: are external forces subduing

underlying price pressures?


External factors

(A) Global factor

(B) Exchange rate

(C) Digitalisation

So, can external factors be blamed for the lack of responsiveness in core inflation?

Note: PPI excludes imports in contrast to NEIG inflation.


Euro inflation outlook:

ECB inflation target remains as elusive as ever

2222

ECB inflation target remains as elusive as ever

• The outlook for HICP and core inflation will remain subdued in our view, leaving the ECB’s inflation projections

again at risk to downward revisions.• A bottom-up analysis of core inflation suggests some acceleration in service price inflation ahead (to 1.7% in

2020-21 from 1.5% in 2019), helped by a fading drag in package tours as well as transport and recreationalservices (see p. 26). Still, not all services categories are likely to be a tailwind to core inflation, as the low-for-longerrate environment is weighing on housing services (see p. 27).

• NEIG inflation, which we expect to decelerate further to just 0.2% in 2020-21 from 0.3% in 2019, presents a less

cheering picture. Despite rising input costs, firms remain reluctant to raise prices. Limited ERPT will leave durablegoods prices in deflation territory in our view and slowing PPI creates downside for non-durable goods priceinflation (see p. 24-25).

• As increasing service price inflation is just about compensating for the increasing drag in the goods category, weexpect core inflation to remain range-bound around 1.1% in 2020-21, leaving the achievement of the ECB’sinflation target as elusive as ever.

HICP

Energy(10%) Food (19%) Core (71%)

Assumptions: Brent oil at 62USD/bbl in 2020 and 60USD/bbl in 2021; EUR/USD at 1.11

in 2019 and 1.13 in 2020


3. Euro inflation outlook: ECB inflation target remains as elusive as ever


2323

Food price inflation set to remain range bound in H1 20 Energy price inflation continues to exert a drag

Headline inflation will not get much boost from higher food or

energy prices near-term

HICP

Energy (10%) Food (19%) Core (71%)

Source : Eurostat, Hamburg Institute of International Economics , Macrobond Financial,

Danske Bank


Assumptions: Brent oil at 62USD/bbl in 2020 and 60USD/bbl in 2021; EUR/USD at 1.11

in 2019 and 1.13 in 2020

Source : Eurostat, Hamburg Institute of International Economics , Macrobond Financial,

Danske Bank

2424

Weakening producer price inflation creates downside for non-durable goods prices

NEIG inflation to stay muted

Limited pass-through from import prices will leave inflation in durables and semi-durables contained

Core

Non-energy industrial goods (NEIG) (37%)

Semi durables (15%)

Durables (13%)

Non-durables (9%)

Services (63%)

Recreation & personal care

(17%)Housing (15%)

Miscellaneous

(12%)Transport (10%)

Package tours & accommodation

(5%)

Communication

(4%)


Note: Assumptions: effective EUR unchanged at November level



2525

Inflation in non-durable goods is running out of air


Core


Semi durables (15%)

Durables (13%)

Non-durables (9%)

Services (63%)


(17%)Housing (15%)

Miscellaneous



(5%)

Communication

(4%)

2018 acceleration in non-durable goods prices driven primarily by electrical appliances and householdgoods but producers’ prices suggest slowdown lies ahead



2626

Service price inflation shows tentative signs of pickup


Inflation in transport and recreation services set to remain elevated due to ongoing wage growth…

Core


Semi durables (15%)

Durables (13%)

Non-durables (9%)

Services (63%)


(17%)Housing (15%)

Miscellaneous



(5%)

Communication

(4%)

…while German package tours’ drag in 2019 is fading



2727

Lower rates imply lower housing inflation

Not all categories of service price inflation will be a tailwind to

core inflation


Core


Semi durables (15%)

Durables (13%)

Non-durables (9%)

Services (63%)


(17%)Housing (15%)

Miscellaneous



(5%)

Communication

(4%)

Communication services to remain a drag

Miscellaneous services set to remain range bound




2828

Overview euro area inflation outlook

Source: Eurostat, Danske Bank


CurrentSparkline

(last 6M)2019 avg. 2020 avg. HICP weight Core weight

HICP 0.73 1.18 1.18 100

Energy price inflation -3.14 1.32 0.16 10.1

Food price inflation 1.54 1.76 1.92 19.0

HICP ex tobacco 0.64 1.11 1.10 97.7

Core inflation 1.07 1.02 1.13 70.9 100

Non-energy Industrial Goods 0.28 0.28 0.21 26.4 37.2

- Durables -0.36 -0.38 -0.36 9.3 13.1

- Semi-durables 0.36 0.35 0.31 10.4 14.7

- Non-durables 1.01 1.10 0.84 6.7 9.4

Services 1.54 1.52 1.67 44.5 62.8

- Communication -0.36 -0.76 0.03 2.6 3.7

- Housing 1.54 1.39 1.44 11.0 15.5

- Package tours & accommodation 0.86 1.13 2.51 3.4 4.8

- Recreation & personal care 1.89 1.93 1.96 11.9 16.8

-Transport 2.42 2.00 1.96 7.2 10.2

- Miscellaneous 1.56 1.53 1.50 8.4 11.8

Danske forecast

Inflation market dynamics:

still looking for the missing catalyst

3030

PMIs pointing to further decline in inflation pressures near term

ECB worries: have inflation expectations de-anchored or re-anchored at a lower level?

Both market and survey-based measures of inflation expectations

continue to slide


Source: Eurostat, ECB, Bloomberg, Markit, Macrobond Financial, Danske Bank

4. Inflation market dynamics: still looking for the missing catalyst


Source: Eurostat, ECB, Bloomberg, Markit, Macrobond Financial, Danske Bank

3131

Over our forecast horizon, we do not disagreesignificantly with the current market pricing,although fixings in mid-2020 look a bit on the lowside to us, despite our conservative assumption onthe core inflation dynamics.

Inflation markets are still looking for the missing catalyst…core

inflation


Source: Bloomberg, Eurostat, Danske Bank


Source: Bloomberg, Danske Bank

4. Inflation market dynamics: still looking for the missing catalyst

The missing catalyst for a more significantrepricing of the inflation curve remains higherrealised core inflation rates. About these themarket remains sceptical, expecting inflation stillcaught in a 1.0-1.5% range over the medium term.

3232

Disclosures

This research report has been prepared by Danske Bank A/S (‘Danske Bank’). The author of this research report is Aila Mihr, Senior Analyst.

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Report completed: 28 November 2019, 15:04 CETReport first disseminated: 29 November 2019, 06:00 CET

Documents

Measuring the euro area inflation pulse · inflation conundrum persists 2. Theme: are external forces subduing underlying price pressures? 3. Euro inflation outlook: ECB inflation