Disappointing eurozone inflation highlights downside risks

After a sharp rise in eurozone inflation at the start of the year, the flash estimate for the Harmonised Index of Consumer Prices (HICP) for May has shown a larger-than-expected fall in annual inflation. Eurozone annual inflation fell from 1.9% in April to 1.4% in May, and compares to consensus estimates of 1.5%.

While the April figures were artificially high due to the timing of Easter, the lower-than-expected results for May suggest that inflation is likely to fall faster than most expect.

Within the details of the latest data, core inflation (excluding energy, food, alcohol and tobacco) fell from 1.2% to 0.9%, also disappointing consensus expectations. Meanwhile, energy inflation fell from 7.6% to 4.6%, as it continues to fall from its peak in February. Lastly, food, alcohol and tobacco inflation remain unchanged at 1.5%.

Softer inflation can benefit consumers

Higher inflation in the first quarter is likely to have caused households to cut back spending as wage growth remains subdued. Eurozone retail sales fell from 0.8% in the fourth quarter (quarter-on-quarter) to just 0.3%. Therefore, inflation falling back is likely to help households by boosting their purchasing power.

However, while lower inflation is generally welcomed, when inflation is too low, concerns over deflation1 start to surface. This has been a big risk in the monetary union over the past two years, and is the reason for the aggressive monetary policy easing being conducted by the European Central Bank (ECB).

Monetary policy to remain accomodative

Looking ahead, we forecast inflation to fall back to around 1% by the start of 2018 as the impact from recent higher energy prices fully fades. This is likely to be too low for the ECB, and so we expect quantitative easing to continue over most of next year, albeit with a lower amount of monthly purchases. Unemployment remains too high in the eurozone to worry about an inflation overshoot, and the latest inflation disappointment highlights the downside risks that still prevail.

1. Deflation is a sustained fall in the prices of goods and services. It is the opposite of inflation.