Market Data Suggests Fading EZ Inflation Ahead

Summary

• Housing energy and vehicle fuel costs are driving European inflation. Vegetable oils/fats also play an outsized role.
• As expected, these datapoints move in line with some lag of the raw goods’ more timely market price data.
• We find each of the largest inflation drivers should start to experience negative YoY base effects into May’s HICP.
• While it probably won’t cause the ECB to change tack completely, it should soften current hawkish sentiment and renew emphasis on the gradualism of subsequent normalisation.

Persistent, Supply-Driven EZ Inflation Has Policymakers Worried

Energy has played a large role in pushing Eurozone HICP higher. It continues to be the major driver of price rises in the near term. So far, the ECB’s doves have been loath to act because external, supply-side factors, rather than domestic demand, are driving inflation. But the persistence of the price rises seems to be winning them over to the more hawkish side.

The ECB meeting on 21 July is becoming a more mainstream view for the date of the first rate hike. And ECB policymaker comments increasingly support this (although September just about retains the majority vote for now). Before then, we will see both the final April HICP reading (18 May) and the preliminary May reading (31 May). These could prove more dovish than the market is pricing.

Recently, the overwhelming driver of inflation has been the Housing and Transport components (Charts 1 and 2). Chart 3 presents a more detailed breakdown of what this includes. Meanwhile, Chart 4 shows the contribution each sub index made to March’s YoY number (the latest reading with this breakdown).

The sections highlighted with red outlines in Charts 3 and 4 account for less than 20% of the index weighting, but 65% of March’s YoY HICP number. We examine these segments for indications of when base effects will turn negative.

Negative Diesel, Electricity And Cooking Oil Base Effects Ahead

European Gasoil (Diesel) Price

By EU data, oil is the most consumed transport fuel for Europe (see here for our analysis on the uses of fuels across Europe). However, looking at market traded futures, diesel price rather than crude oil most closely tracks the inflation reading (Chart 5). Diesel supply has suffered from both the rise in oil price, and the shift away from heavier Russian oil blends (which typically yield more diesel). However, without another surge in price, the base effects should begin to fade in the next two months, taking 2ppts off the segment’s YoY reading in each of May and June.

German Baseload Electricity Price

Meanwhile, in household electricity, the HICP reading correlates well with a three-month lag of the forward 1wk German baseload electricity price (Chart 6). This suggests there could be significant negative base effects coming in the next few readings, before more positive effects feed in. More likely, the effects will be more smoothed than the chart suggests. That should still leave a net-negative effect ahead.

Cooking Oil Prices

Finally, the damage to Ukrainian sunflower-oil production has raised cooking oil and fat prices. And Indonesian restrictions on palm-oil exports have compounded the situation. Given substitution effects, the prices of other cooking oils to which the EU is most exposed (particularly rapeseed) have also risen. There will also be a crossover factor with diesel due to the fact that while vegetable oils are still predominantly used in food (45% EU consumption), they are increasingly being used in biodiesel (42%).

In 2020, rapeseed oil accounted for 34% of total oil produced in and imported into the EU and UK, palm oil accounted for 25%, and sunflower oil accounted for 21% (Chart 7). Weighting by these proportions, and translating the respective market futures prices into EUR (soya, palm, sunflower and rapeseed oil contracts), we find that current cooking oil inflation correlates most strongly with market prices with a 12-month lag (Chart 8). While intuitively such a long lag might seem strange, taking shorter lags still produces a net negative base effect.

Conclusion

We have examined timely market pricing data across the largest recent drivers of EZ HICP inflation. In sum, the data suggests that if market prices were to stay flat, or fall ahead, the base effects will be significantly negative across diesel and electricity, and mostly negative for cooking oils.

When May preliminary HICP comes out at the end of the month, inflation could very likely see downside impulses from these factors. While clearly the ECB is getting less comfortable with high inflation, this could provide some ammunition for the doves. This may be sufficient to see retracement of some of their more hawkish recent comments around a July hike. More likely it will allow them to strongly emphasise the need for gradualism after the initial hike.

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.