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Investment Research — General Market Conditions
The euro area slipped into deflation in December 2014 and we expect the
inflation rate to remain negative during most of 2015.
The current outlook for deflation is not dangerous, as it is mainly driven by the
oil price drop, which only has a temporary impact on energy price inflation.
Inflation is set to turn positive again in 2016 even if the oil price remains at the
current very low level.
Nevertheless, around a year of deflation gives a significant risk of second-round
effects, where wages and inflation expectations follow inflation lower.
The ECB cannot do much about lower oil prices, but it can reduce second-round
effects by a credible monetary policy, which stabilises inflation expectations.
We expect the ECB to announce QE at the meeting on 22 January and focus
should be on providing enough stimulus to support inflation expectations. Furt-
her easing would also support inflation through a continued euro depreciation.
Fixed income and inflation swap markets are sensitive to changes in energy
prices, and the oil price drop is pushing down the pricing of future inflation.
From a trading perspective, a necessary condition for positioning for a rebound
in B/E inflation is that oil prices stop sliding, but we are still not there yet.
Deflation during most of 2015 – but mainly due to falling commodity prices
Source: Eurostat, Danske Bank Markets
14 January 2015
Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 [email protected]
Senior Analyst Lars Tranberg Rasmussen +45 45 12 85 34 [email protected]
Research papers:
Recovery despite deflation
12 January
Short-term weakness fades
13 January
Deflation but the good kind
14 January
ECB will buy government bonds
15 January
Impact of broad-based QE
16 January
Euro area outlook for 2015
Deflation but the good kind
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Deflation during most of 2015 mainly due to the oil price decline
The euro area slipped into deflation in December on the back of the significant decline in
the oil price. Looking ahead, we expect headline inflation to decline further and already in
January it is likely to fall to -0.4% y/y. This should follow as the oil price has continued
its free fall at the beginning of 2015, while it also reflects that the full impact from the
latest sharp decline in the oil price has not been seen yet.
Based on the low oil price, we expect headline inflation to remain negative until Q4 and
be -0.1% on average in 2015. This is clearly below the Bloomberg consensus that
inflation will be +0.6%. Nevertheless, we see downside risk to our inflation forecast, as
long as the oil price continues to reach new lows.
Euro deflation during most of 2015... ... mainly due to the decline in the oil price
Source: Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets
The negative inflation is mainly due to the oil price decline, but it also reflects that core
and food price inflation are low in a historical perspective. During summer 2014 food
price inflation was negative for the first time since the financial crisis, while core inflation
has balanced around its new historical low of 0.7% since September.
Although core inflation is low, the current deflation is not a dangerous kind. First, as we
have argued in Recovery despite deflation, the lower energy price inflation boosts private
consumption through higher real wage growth. Added to this low core inflation primarily
reflects low inflation in non-energy industrial goods, which has been negatively affected
by the euro strengthening. On the other hand, service price inflation, which is highly
dependent on labour as an input and closely related to wage growth, has remained
relatively stable.
Lower commodity prices gives higher real wage growth Low core inflation due to non-energy industrial goods inflation
Source: ECB, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets
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Having said that, the outlook for deflation for almost a year increases the risk of
unanchored inflation expectations. This also follows as the low rate of inflation is broad-
based. Currently, 50% of the inflation components in HICP are below 1%, which is worse
than what was observed during the financial crisis. The worsening reflects that the share
of inflation components in deflation has increased from around 10% in 2012 to above
30% at end-2014, while the share of components with inflation between 0% and 1% has
increased from 10% to around 20%.
The very low price pressure is broad-based 50% of the inflation components are below 1%
Source: Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets
Higher inflation in 2016 even if the oil price does not recover
Looking ahead, we expect the oil price to eventually increase from the very low level and
the experience of the 1986 oil glut indicates that the oil price will recover to USD85/bl in
the medium term. We are still not there yet, but when the oil price stabilises it will
increase the contribution to headline inflation from energy prices but with a lag. Based on
this we expect headline inflation will turn positive again in October.
Even if the oil price does not increase but remains at the current level, headline inflation
should turn positive again in the beginning of 2016. This follows as the low energy price
inflation only reflects first-round effects of the oil price decline, which has no lasting
deflationary effects, but only gives a lower price level.
There is also evidence of indirect effects of the oil price decline in some energy intensive
producer prices as well as in consumer service prices related to transport. But in line with
the effect on energy price inflation the effects are only temporary although there is a
longer lag before these effects are seen.
Energy price inflation set to go higher with unchanged oil price HICP inflation turns positive in 2016 with unchanged oil price
Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets
5Y5Y inflation exp
headline inflation
core inflation
wage growth
short term unemp
food price inflationglobal food prices [EUR]
taxes
energy price inflation
oil price [EUR]
effective exchange rate
Newest data Q4 2007
higher pricepreassure
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Risk of second round-effects
The risk is that the oil price decline results in lasting and much more dangerous
deflationary effects. This will be the case if the oil price decline results in second-round
effects where wages and inflation expectations follow inflation lower. Lower wage
growth would follow due to wage indexation but could also be seen under wage
negotiation processes as the low inflation makes it easier for employers to argue for low
nominal wage growth. The risk of deflationary effects increases further if inflation
expectations are unanchored by changes in energy prices.
The second-round effects are generally hard to measure, as wage setting is also affected
by the business cycle situation, competitive pressure across markets and the wage-setting
institutions. But in our view there have been signs of second-round effects as wage
growth is down at 1.3% y/y, which is the lowest rate in more than 10 years.
The latest decline in wage growth is not a result of a worsening in the labour market as
the unemployment rate has declined and employment growth has turned positive. The
short-term unemployment rate, which is a good leading indicator for wage growth, is also
lower. However, the lack of spill-over to wages is also due to the large amount of slack in
the labour market and cannot only be seen as second round effects.
Sign of second round effects in wage growth Weak price pressure also due to slack in the labour market
Source: ECB, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets
Another sign of second round effects is the decline in inflation expectations. As
mentioned above, this reinforces the downward pressure on wages, and the risk is that
inflation is shifting to a lower equilibrium level below 2% as wage earners become
satisfied with lower wage increases when prices are expected to increase at a slow pace.
Market based inflation expectations far from the target Professional forecasters’ inflation expectations are also lower
Source: Bloomberg, ECB, Danske Bank Markets Source: ECB, Danske Bank Markets
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The ECB cannot do much about falling oil prices and the low energy price inflation, but it
can reduce second-round effects by a credible monetary policy strategy, which stabilises
inflation expectations. In light of this we expect the ECB to announce government bond
purchases at the meeting on 22 January. Focus for the ECB should be on providing
enough stimulus to a) convince wage earners that they should expect 2% inflation and b)
generate enough demand to get unemployment down and dampen the downside pressure
on wage increases.
Weaker euro puts upwards pressure on inflation
Further monetary easing from the ECB should at the same time support inflation through
a weakening of the effective euro. This follows as the currency depreciation boosts import
prices, which in turn puts upward pressure on domestic prices. Based on our expectation
that the ECB will announce QE in January the effective euro should weaken further
during H1 and the aggregate weakening of around 10% should support inflation by
around 0.3pp in 2015 and 0.7pp in 2016.
The main impact of the euro weakening should be seen in non-energy industrial goods
inflation. However, it printed negative in Q4 14 and we are still waiting for the first
evidence that the impact of the past euro strengthening is waning. The risk is that the
impact on inflation will be smaller than usually as companies are absorbing the impact of
the currency depreciation due to weak demand and/or low inflation expectations.
Looking ahead, we expect private consumption to continue to increase, implying
companies will be more confident that lack of demand is not a concern. Based on this we
expect the pass-through to consumer prices of the cost of the currency depreciation to be
seen in H1. Added to this further easing from the ECB will strengthen the spill-over if the
monetary easing results in higher inflation expectations.
Euro depreciation puts upward pressure on inflation 10% euro weakening should increase inflation by 0.3pp in 15
Source: Bloomberg, Danske Bank Markets Source: OECD, Danske Bank Markets
The conclusions above imply we expect core inflation to slowly increase during our
forecast horizon. This should also follow as the stronger recovery will continue to give a
lower unemployment rate which supports wage pressure. However, the large amount of
slack in the labour market should imply that the impact on wage growth will be modest.
In light of this we expect a decline in core inflation to 0.5% y/y in March.
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Second-round effects also reflected in structural changes
The second round effects are also seen by a downward shift in the Philips curve (relationship between rates of unemployment and corresponding rates of inflation) as this reflects a lower rate of inflation for the same rate of unemployment. We have included the labour dependent service price inflation in our Philips curve, hence the downward shift reflects lower wage growth, which is likely to be due to a decline in inflation expectations. This structural change in the labour market is also reflected by a change in the relationship between the unemployment rate and the job vacancies (the Beveridge curve). The Beveridge curve shifted upwards at the beginning of 2010, as there was an increase in job vacancies which was not caused by an increase in the unemployment rate.
Source: Eurostat, Danske Bank Markets Source: Eurostat,EU Commission, Danske Bank Markets
*Job vacancy is measures as limited production due to labour
Steep inflation curve
Global fixed income and inflation swap markets are sensitive to changes in energy prices,
and currently the drop in oil prices in particular is pushing down the market pricing of
future inflation (break/even inflation). In some sense, this is counterintuitive since, at
least for the euro zone, we should expect that lower energy prices should eventually lead
to higher private demand and hence higher future inflation. This view is to some extent
reflected in the B/E curve, which is steep as seen in the chart below, where we have
derived 1Y forward gaps from the current spot B/E curve. The forward rates are
consistent with the market pricing in a return to positive inflation already in 2016 and
then a gradual increase towards 1% when adjusted for estimated term premiums.
Steep inflation curve Inflation priced to move above 1%
Source: Danske Bank Markets Source: Danske Bank Markets
To get a sense of the dynamics of the B/E curve we have made a simple principal
component analysis (PCA). Interestingly, the PCA shows that one factor alone drives
more than 80% of the total monthly variation of the curve. And judging from the loading
of the first principal component is it pretty clear that the B/E curve to a very large extent
is driven by the front of the curve.
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
Oct-15 Oct-17 Oct-19 Oct-21 Oct-23
B/E 1yr gaps
% %
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
1 2 3 4 5 6 7 8 9 101y
r f
wd
in
fla
tio
n
Years
B/E adjusted for term premium
Estimated term premium
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A simple principal component analysis shows that one factor
drives 84% of the total monthly variation in the curve
Loading on principal component shows that the curve is
driven from the front
Source: Danske Bank Markets Source: Danske Bank Markets
From a trading perspective this implies that a necessary condition for positioning for a
rebound in B/E inflation is that oil prices stop sliding and hence short-term inflation
expectations stabilise. We are still not there yet. However, as most of the oil price decline
is now behind us, we believe a more prudent strategy for the current environment would
be to position for a flatter B/E curve, as investors could benefit from attractive roll-down
and get some protection against the expectations of a rebound in inflation.
0%10%20%30%40%50%60%70%80%90%
PC1 PC2 PC3 PC4-14
0.00
0.10
0.20
0.30
0.40
0.50
Loading on PC1
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Disclosure This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske
Bank’). The authors of the research report are Pernille Bomholdt Nielsen, Senior Analyst, and Lars Tranberg
Rasmussen, Senior Analyst
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