TalkingEconomics: Europe - could higher inflation curtail central banks' stimuli?
After years of deflationary dynamics, energy inflation is set to lift European and UK inflation significantly over the next few months. However, the energy effects will only be temporary and will have a deflationary impact in the medium term.
3 November 2016
Investors have been concerned about deflation risk 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.
Eurozone inflation set to return
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).
All else equal (i.e. if core inflation, food, alcohol and tobacco prices stay stable), we predict this rise in energy inflation will push the headline rate of eurozone inflation to about 1.9% by the end of the first quarter of 2017. However, the impact from energy then fades, suggesting a fall in the headline rate back below 1%.
Fall in sterling to exacerbate the rise in UK inflation
The UK faces similar energy inflation dynamics; however, the rise in inflation is likely to be exacerbated by the fall in sterling following the UK’s decision to leave the EU. The fall in the pound will not only raise energy prices, but food prices and import prices for goods more generally too.
Taking both factors into account, we forecast UK Consumer Price Index (CPI) inflation to rise to above 3% y/y by the middle of 2017, averaging 2.9% over the year as a whole. This is an interim estimate from our quarterly forecast which will be revised in next month’s publication.
Implications for central banks
The European Central Bank (ECB) could find it tricky to add further stimulus as inflation rises in the near term. To make the communication of ongoing stimulus easier, we suggest the extension of quantitative easing (QE) should be announced sooner rather than later. We assume the announcement will take place at the 8 December meeting.
In the UK, while inflationary in the near-term, the fall in sterling and the rise in imported prices will be deflationary further out. The Bank of England (BoE) has always focused on a medium-term inflation target and for the moment, we assume the authorities will maintain the current loose policy environment, and may even loosen further in 2017.
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.