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Investment Research — General Market Conditions
In this second document in our series, we focus on eurozone inflation. Looking at
different factors such as monetary and fiscal policy, the oil price and exchange
rate impact as well as evidence on rising wage growth, we conclude that the
balance of risks to our inflation forecast (1.4% and 1.3% in 2018 and 2019,
respectively) and market pricing lies clearly on the upside, particularly in 2019.
We expect the impact of monetary and fiscal policy on euro area inflation in 2018
and 2019 to be balanced: while euro area fiscal policy might become moderately
more expansionary in 2019, we believe gradual ECB monetary policy
normalisation will increasingly become a disinflationary factor.
We see upside risks to our inflation forecast from the direct and indirect effects of
higher oil price rises but we believe the stronger euro will increasingly act as a
mitigating factor from H2 18 onwards.
In light of the lack of a clear upward trend in super core inflation, we remain
sceptical about a strong pickup in core inflation in the near term. This said, there
are clear upside risks to core inflation, primarily in 2019, stemming from the
strong growth momentum and early signs of rising wage pressures.
Balance of risks to eurozone inflation lies on the upside
As discussed in Part 1: Global Inflation – US stimulus and closing output gaps pose upside
risk, 26 February, many factors have recently contributed to renewing the market’s belief
that reflation has finally arrived. Higher oil prices and the strong euro area expansion
together with signs of rising wage growth have fuelled similar beliefs in the eurozone.
However, despite the increasingly favourable environment on the global front for
reflationary forces to materialise, what is the evidence for the euro area, where inflation
pressures remain very subdued and well below levels that would allow the ECB to raise
interest rates anytime soon?
Markets are still pricing a very subdued outlook for euro area inflation over the next
two years, with a profile that is for the most part below our relatively conservative inflation
forecast, which is HICP inflation at on average 1.4% in 2018 and 1.3% in 2019 (see Chart 1).
Table 1. The balance of risks to eurozone inflation lies on the upside, especially for
2019
Source: Danske Bank
Global forces Moderate Upside Upside
Euro zone fiscal/monetary policy Balanced Balanced
Oil price rise Upside Upside
EUR appreciation Balanced Downside
Wage growth Moderate Upside Upside
Total Moderate Upside Upside
20192018
27 February 2018
Analyst Aila Mihr +45 45 12 85 35 [email protected]
Assistant Analyst Christian Belling Sørensen [email protected]
Part 2: Eurozone Inflation
Upside risks from oil prices and rising wage pressures
Inflation and markets
Part 1: Global Inflation, 26 February
Part 2: Eurozone Inflation, 27 February
Part 3: Scandi Inflation, 28 February
Part 4: FI Implications, 1 March
Part 5: FX Implications, 2 March
Special issue on 27 February: The
Remarkable Decline in Emerging Market
inflation: Facts and investment implications
Chart 1. Markets pricing inflation
below our forecast in 2019
Source: Eurostat, Macrobond Financial, Danske
Bank
2 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
Looking at different factors such as monetary and fiscal policy, the oil price and exchange
rate impacts as well as evidence on rising wage growth in more detail below, we think the
balance of risks to our inflation forecast clearly lies on the upside in the magnitude of
approximately 0.2-0.4pp, particularly in 2019 on the back of rising wage pressures (see
Table 1). Such a higher profile would be in line with the ECB’s current inflation forecast,
which expects HICP inflation to be 1.5% in 2019 and 1.7% in 2020. This said, it remains
uncertain whether, and to what degree, the above-mentioned factors will materialise.
Hence, we stick to our original inflation forecast for now. However, we stress that we
see upside potential for inflation market pricing, especially for the low levels in 2019.
Muted inflation impact of fiscal and monetary policies
We expect fiscal policy in the eurozone to be only moderately expansionary in 2019, with
limited impact on inflation. Despite the new German government’s plan to increase
infrastructure spending and lower social security contributions, the overall fiscal loosening
is modest in size (EUR46bn) and spread out over 2018-21, meaning the overall fiscal stance
in Germany will remain relatively neutral (for details, see also Part 1: Global Inflation –
US stimulus and closing output gaps pose upside risk, 26 February). Irrespective of its
composition, the new Italian government is likely to pursue a moderately expansionary
fiscal policy, as all parties are calling for higher public spending. However, actual policies
may be more moderate than envisaged, given the tight surveillance that Italy is under vis-
à-vis the European Commission due to its high debt ratio.
Different measures of the monetary policy stance in the euro area point to somewhat mixed
evidence (see charts 2 and 3) but with the ECB starting to embark on a gradual path of
policy normalisation, we expect less accommodative monetary conditions in the euro area
in 2018 and 2019. Excess liquidity is likely to remain sizable in the near term as long as
the ECB continues its QE reinvestments but, despite the strong balance sheet expansion
since the advent of QE in 2015, broad and narrow money supply growth remained fairly
stable and at a below pre-crisis level (see Chart 4). This disconnect is reflected in the decline
in the money multiplier – possibly due to regulatory changes to banks’ capital and liquidity
reserves limiting the effectiveness of the monetary transmission mechanism.
Chart 2: Nominal GDP growth relative
to the ECB policy rate points to less
expansionary ECB policy since 2016
Chart 3: Difference between the
natural and real policy rate points to
more accommodative ECB policy
Source Macrobond Financial, Danske Bank Source: OECD, Macrobond Financial, Danske Bank
Overall, we expect the effect of monetary and fiscal policy on euro area inflation in
2018 and 2019 to be balanced: while euro area fiscal policy might become moderately
more expansionary in 2019, we believe gradual ECB monetary policy normalisation
will increasingly become a disinflationary factor.
Chart 4: Money supply growth
remains flat in light of declining
multiplier
Source: ECB, Macrobond Financial, Danske Bank
3 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
Upside risks from continued oil price rises but euro
appreciation set to become a mitigating factor
Oil prices in USD terms have risen sharply since mid-2017 but the impact on inflation in
the euro area has been mitigated partly by a similar steep rise in the EUR/USD exchange
rate. In euro terms, oil prices have risen by 7.6% on average in 2017 and via the direct
effect on the energy component of HICP will lift euro area headline inflation in coming
months. Apart from the direct effect on energy price inflation, oil prices also affect other
HICP components via production costs. Core inflation items such as services related to
transport, package tours and non-durable goods that are produced with high energy-
intensity will also be lifted by higher oil and producer prices in 2018 (see Chart 5), although
the effects take some time to feed through. This said, oil or oil-related input costs are only
one factor in firms’ pricing decisions and strategic considerations vis-à-vis competitors and
the cyclical position of the economy may also play an important role in determining the
degree of indirect effects of oil price rises showing up in core inflation.
According to an ECB study, a 7.6% increase in oil prices in euro terms would give rise to
a 0.3pp increase via direct effects on the energy component – most of which would happen
relatively quickly – and an approximate 0.15pp increase via other HICP components over
a period of up to three years. However, even when assuming continued steep oil price
increases compared with our base scenario (Brent oil at USD63/bl in 2018 and USD65/bl
in 2019), the impact on the inflation profile would decline from mid-2018 onwards due to
base effects (see Chart 6). Hence, to create a lasting impact on the inflation profile, it is
important that higher oil prices also affect inflation expectations and the wage formation
process (i.e. so-called second-round effects materialise – see Chart 7).
The actual impact of the direct and indirect effects of oil price rises on euro area inflation
may be blurred by the offsetting effect of the continuing euro appreciation. A stronger
EUR/USD exchange rate not only mitigates oil price increases in euro terms but ceteris
paribus also creates upward pressure on the effective euro exchange rate (EER-38) and
thereby lowers import prices. This spills over to lower prices for non-energy industrial
goods (see Chart 8). Assuming an unchanged effective euro for the rest of 2018, we obtain
an annual appreciation of the effective euro exchange rate of around 4.1% (see Chart 9).
Using elasticities from the OECD’s new global model, the 4% stronger effective euro
would drag down headline inflation by around 0.1pp after one year and an accumulated
0.3pp after two years.
Chart 9: Strong depreciation in
effective EUR over 2015…
Chart 10: should moderate EUR
appreciation impact on inflation in 2018
Source Macrobond Financial, Danske Bank Source: OECD, Macrobond Financial, Danske Bank
-0.5
-0.4
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
2017 2018 2019 2020
pp Impact on inflationfrom currency moves(The effective euro is assumed unchanged at current level)
Effect of changes until 2014 Effect of depreciation in 2015
Effect of appreciation in 2016 Effect of appreciation in 2017
Effect of appreciation in 2018 Aggregate effect on inflation
Chart 5: Core inflation items
supported by higher oil price
Source: Eurostat, Macrobond Financial, Danske Bank
Chart 6: Energy price impact set to
moderate in 2019 due to base effects
Note: Assumptions: EUR/USD at 1.22 in 2018
and 1.29 in 2019, Brent oil at USD90/bl end-
2018 and USD100/bl end-2019
Source: Eurostat, Macrobond Financial, Danske Bank
Chart 7: Oil price rise needs to give
rise to second-round effects to have
lasting impact
Source: ECB, Danske Bank
Chart 8: NEIG inflation negatively
impacted by EUR appreciation
Source: Eurostat, Macrobond Financial, Danske Bank
Oil price
(in EUR)
HICP inflation
Producer
prices
WagesInflation
expectations
First-round
effects
Second-round
effects
Directeffects Indirect
effects
4 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
However, quantifying the exact pass-through to HICP inflation is difficult, as changes in
the exchange rate take about two years to pass through fully to inflation and at any point in
time the net effect is always a combination of lagged effects of past exchange rate
movements. Therefore, the total exchange rate effect on inflation in 2018 will still be fairly
modest, as the euro appreciation in 2016-17 is counterweighted by the effect of the large
euro depreciation in 2015. The full impact will hence become mainly apparent in 2019 and
could lower headline inflation by up to 0.4pp (see Chart 10).
We think the actual degree of exchange rate pass through might be lower as implied by the
model above due to a range of factors, including: (1) upward pressure on producer prices
of euro area trading partners due to oil; (2) growing currency invoicing of extra-euro
imports in euro; (3) a stable inflation environment, which makes firms more reluctant to
adjust prices to transitory exchange rate shocks; (4) part of the rise in EUR/USD has also
been driven by the weaker USD leg and (5) the stronger exchange rate is at least partly also
a reflection of stronger domestic demand.
As we see risks to our current oil price forecasts mainly on the upside, we conclude
that there are also upside risks to our inflation forecast from the direct and indirect
effect of oil price rises but, in our view, the stronger euro will increasingly act as a
mitigating factor from H2 18 onwards.
Ambiguous outlook on higher euro area wage growth and core
inflation
In line with the rise in oil prices, we have observed an increase in market inflation
expectations from the trough in July 2017 (see Chart 11), likely reflecting growing market
confidence in second-round effects materialising due to the continued strong global and
euro area economic momentum. However, wage growth is still the missing link for higher
underlying inflation pressures in the euro area and evidence for higher wage growth
remains ambiguous.
Although the fall in unemployment has continued to be stronger, as suggested by the pace
of economic expansion, wage growth has remained contained, probably due to lower trend
labour productivity growth (see Chart 12) and remaining slack in the labour market when
looking at broader unemployment measures, especially in periphery countries.
Nevertheless, as unemployment is slowly closing in on NAIRU, early signs are emerging
that wage growth is gradually picking up from the low levels of 2013-16 (see Chart 13).
Consumer price expectations have reached the highest level since 2013 and increasing
capacity constraints and labour shortages should exert a positive impact on negotiated
wages (see Chart 14).
The current strong growth momentum in the euro area is further raising the odds of second-
round effects materialising. However, so far, underlying inflation measures such as super-
core inflation, which includes only HICP items with a statistically significant and positive
link to movements in the output gap, do not yet point to a turning point in the underlying
inflation pressures. Historically, super core has reacted to movements in the output gap
with around a six-month lag. However, this link has weakened since 2015 (see Chart 15),
potentially due to a shrinking number of HICP items that react to the output gap, as the
ECB also recently noted. In light of the lack of a clear upward trend in super core, we
remain sceptical though about a strong pickup in core inflation in 2018.
Chart 11: Market inflation
expectations have recovered
Source: Bloomberg, Macrobond Financial, Danske
Bank
Chart 12: Trend productivity growth
has declined
Source ECB, Macrobond Financial, Danske Bank
Chart 13: Wage growth has started to
pick-up…
Source: Macrobond Financial, Danske Bank
Chart 14: …supported by increasing
labour shortages
Source: Macrobond Financial, Danske Bank
5 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
This said, the balance of risk for core inflation due to the strong growth momentum
clearly lies on the upside. Assuming that GDP growth in 2018 remains at similarly high
levels as in 2017 (for illustration we assume here 2.5% in 2018 and 2.3% in 2019 versus
our baseline of 2.0% and 1.8% in 2018 and 2019, respectively), Okun’s Law, which links
developments in unemployment to GDP growth, points to continued employment gains
(see Chart 16). Using the predicted unemployment values, the current shape of the Phillips
curve would imply core inflation of around 1.7% by the end of 2018 and 1.8% by end-2019
(see Chart 17).
Chart 16: Continued strong growth
and employment gains…
Chart 17: …raise upside risks to core
inflation
Source Eurostat, Macrobond Financial, Danske Bank Source Eurostat, Macrobond Financial, Danske Bank
IG Metall wage negotiations: limited upside risks for German
core inflation in 2019
What is the evidence so far that second-round effects have started materialising, looking at
the example of the recently concluded German IG Metall wage negotiations? With a
lifespan of 27 months, we estimate that the IG Metall agreement equates to around 3.5%
wage growth for metal and electro workers in 2018 and 3.3% in 2019. Although this is
higher than wage settlements in recent years, it is also not unusually high from an historical
perspective (see Chart 18).
What does the IG Metall settlement mean for overall wage growth in the euro area’s biggest
economy and will it ultimately help the ECB to achieve its inflation target? At least on the
latter, we remain sceptical. The IG Metall settlement affects around 3.9m workers in the
German metal and electro industry, which constitutes only around 9% of the total German
labour force, so the impact on negotiated wages in the whole economy will depend on
spillover effects on other sectors of the economy. Early signs of this are already emerging,
with a similar union demand of 6% wage increase for 12 months in the upcoming public
sector bargaining round (affecting some 2.5m workers).
IG Metall wage agreements have historically been a good predictor of aggregate German
negotiated wages one year head. A simple regression model points to negotiated wage
increases of 1.6% in 2018 and 2.4% in 2019, which is still below previous peaks (see Chart
19). However, what ultimately matters for inflation is wage increases relative to
productivity growth (i.e. unit labour costs) and unless wage growth accelerates beyond
productivity growth in a sustained manner, we expect inflation rates to remain low.
Assuming unchanged labour productivity growth of 1.3% in 2018 and 2019, our negotiated
wages forecast points to unit labour costs growth still well below the ECB’s 2% target (see
Chart 20). Given the close link between unit labour costs and core inflation (see Chart 21),
this leaves us to conclude that the IG Metall wage settlement in isolation points to only
limited upward pressure core inflation in 2019.
Chart 15: Super core inflation shows
no clear upward trend yet
Source: ECB, Macrobond Financial, Danske Bank
Chart 18: Higher IG Metall wage
settlement in 2018/19
Source: IG Metall, Danske Bank
Chart 19: IG Metall agreement points
to only moderately higher negotiated
wages
Source: Eurostat, Bundesbank, Macrobond
Financial, Danske Bank
Chart 20: Unit labour costs growth to
remain below ECB’s target
Source Eurostat, Bundesbank, Macrobond
Financial, Danske Bank
6 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
Another dampening factor is that collective bargaining agreements cover only 45% of
employees in Germany and negotiated wage increases in recent years have already been
relatively high in light of low inflation and labour productivity. Therefore, it is important
that higher negotiated wages spill over to sectors not covered by collective bargaining as
well. The new German government’s plan to reduce the number of temporary contracts
could become a supporting factor for this spillover to materialise. Furthermore, the
government is also planning to return to parity in the financing of contributions to the
German statutory health insurance. This would act as an increase to employers’ social
security contributions and thereby exert upward pressure on wage growth.
Chart 22: New jobs increasingly filled
by Eastern Europeans
Chart 23: Germany already has a high
labour force participation
Source: Destatis, BAMF, Macrobond Financial,
Danske Bank
Source: OECD, Macrobond Financial, Danske Bank
Previously, net immigration from other EU countries has been a dampening factor on
German wage growth. From 2013-16, almost one-third of jobs created in Germany were
filled by Eastern Europeans (see Chart 22). However, we expect this trend to reverse as a
marked acceleration in domestic wage growth in Eastern European countries is reducing
incentives to seek employment in Western Europe. Given that Germany’s labour force
participation is already quite high compared with the European average and is unlikely to
increase much further (see Chart 23), we expect issues of labour shortages to become only
more pronounced in the future, strengthening employees’ bargaining position.
Overall, in isolation, we see only limited upside potential from the IG Metall
settlement on German core inflation in 2019. A significant rise in core inflation
remains dependent on whether successive wage rounds in other sectors can replicate
similar higher wage settlements. However, increasing issues on labour shortages and
plans by the new German government to reduce the number of temporary contracts
and increase employers’ social security contributions raise the prospect that we will
see higher wage growth in Germany in 2019.
32%
11%
6%4% 4% 2%
TotalEastern
European
Romania Poland Croatia Bulgaria Hungary
Share of increase in German employment from 2013-2016
Chart 21: Close link between unit
labour cost and core inflation
Source: Eurostat, Bundesbank, Macrobond
Financial, Danske Bank
7 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
Disclosures This research report has been prepared by Danske Bank A/S (‘Danske Bank’). The authors of this research report
are Aila Mihr, Analyst, and Christian Belling Sørensen, Assistant Analyst.
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8 | 26 February 2018 www.danskeresearch.com
Part 2: Eurozone Inflation
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Report completed: 26 February 2018, 15:26 CET
Report first disseminated: 27 February 2018, 07:00 CET
