Ignore the Headline(s), Eurozone Inflation is Not Fading

Summary

• July national Eurozone inflation outturns confirmed that headline rates are returning towards a trajectory typical of the pre-COVID period.
• Much of this is due to energy and transport inflation falling out. The question is whether this will continue ahead with gas and oil prices rising.
• The trajectory for core inflation should be more concerning for the ECB – it has deviated back from typical levels recently.
• Wage-intensive services sectors are one driver of this – the momentum there is high and continually rising.

Market Implications

• We continue to see value positioning for ECB hawkishness, particularly versus the BoE via 2s10s GBP/EUR box (GBP steepener vs EUR flattener).

EZ Headline Inflation is Returning to Normal

Spain’s harmonised HICP was confirmed at +2.1% YoY in July. French inflation is higher at +5.1%, Italy’s higher still at 6.3%, while Germany’s is the highest at +6.5%. This may seem a decent way away from the ECB’s 2% target, but, in reality, the recent momentum has been very favourable.

Taking MoM headline inflation, adjusting for the pre-2020[1] typical outturns of that month, and taking a rolling three-month sum, we can see the SA momentum in the headline inflation number has dropped back sharply since mid-2022 (Chart 1).

For the EZ as a whole, the three-month headline inflation deviation sits at +0.4ppt as of the July preliminary reading. With a pre-COVID average HICP of around 1%, this suggests the headline measure is currently running at a rate consistent with annual inflation just 0.6ppt above target[2]. By contrast, the UK’s own suggests a rate closer to 6%.

This may appear to fly in the face of our continued expectations for relative ECB hawkishness, but why headline has been falling so quickly will be the most important aspect.

Energy Disinflation Cannot Last Forever

In short, energy has been a driving factor – in both household and transport prices. However, there are headwinds ahead. The sudden rise in LNG and European gas prices last week on the back of striking Australian LNG workers shows how quickly the situation can change, and how exposed Europe remains to the global energy market. The effect of gas on electricity price effect is diverse between amongst, with Spain’s electricity prices being most affected by wholesale gas, and France’s least (Chart 2). While Viresh sees European gas prices falling ahead, there are still effects to be felt from rising uranium prices (which could be exacerbated by the recent Nigerien coup). That could exacerbate French and German prices which are already suffering from lower powerplant output.

The effect is more universal with regards to oil (and more importantly, diesel) prices and the feed-through into transport inflation. The YoY inflation impulse there has been collapsing across countries since the middle of 2022, but recent price changes suggest this effect will stall ahead (Chart 3).

EZ Core Inflation Continues to Overshoot

Meanwhile, the key question is whether core inflation and wage-intensive services are also normalising. Unequivocally, the core readings have remained significantly above typical levels (Chart 4). For the Eurozone, this equates to a +0.8ppt 3m/3m deviation, or about +4.2% annualised – significantly above target. Troublingly, this number is actually suppressed by the June German train subsidisation and shows little sign of returning to normal beyond that.

No Signs EZ Wage Intensive Services Inflation is Slowing

The wage-intensive services number (around 33% of total EZ services in weightings) is the most important section of inflation with regards to persistence, in our view (and many others). Raw materials costs may fall and sales taxes can be cut, but wages are highly sticky. This is important as the recent momentum in Eurozone wage-intensive services is high and rising, as compared to the decline in UK momentum (Chart 5). The national numbers for July suggest aggregate EZ deviation will decline somewhat in July, but remain strongly above the UK’s.

[1] to exclude COVID and Russian Invasion effects

[2] 1.0% plus (4×0.4%) equals 2.6%

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)