Fundamentals Update: Euro Area Deflation

Euro Area Deflation

Fundamentals Update as at 29 January 2014 by Lorenzo Beriozza

Euro inflation is below the ECB’s 2% target and was 0.8% last December while core inflation reached a new historical low of 0.7%. This month, inflation is expected to be unchanged and inflation is only set to increase slightly in 2015.

Core inflation has declined and is set to remain low in 2014, starting to increase slowly in 2015. This reflects weak price pressure from the labour market due to high unemployment and low labour costs. In 2015, when economic growth is expected to pick up, the unemployment rate should decline and moderate wage growth is expected.

Inflation in food prices increased a bit in December 2013, but due to the decline in global food prices, it will decrease further. Looking ahead, even though demand for grain is on track for a decent pick-up this year, it is likely to be outpaced by an expected increase in supply.

Energy price inflation also increased last month to 0.0%, having been negative for four consecutive months; it should remain around zero. This follows as oil supply is boosted by new technology to make the most of shale formations, while growth in demand is slowing as growth in China is less energy intensive.

The lower inflation is not contradicting stronger growth in the euro area. Lower commodity prices have increased purchasing power and the most recent decline in core inflation is due to methodological changes and not a result of a drop in wage growth. Real wage growth has shown a clear improvement from its previous decline.

Looking at deflation (as calculated by the Euro Area Deflation Index), there are some differences between countries, but all are placed at or below zero in the deflation index. Germany has moved down in the index mainly due to the methodological changes.

The score of the core countries is held up by PMIs and GDP growth not too far below potential growth. Inflation is expected to increase slowly as the recovery puts upward pressure on wages, but lower commodity prices would counter some of it.

The periphery countries are at the low end of the index and inflation should remain very low as high unemployment limits wage pressure. This is partly due to an adaptation of competitiveness, which is necessary to restore sustainable economic growth.

Source: Danske Bank